Enter your email address to follow ECNFIN.com and receive notifications of new articles by email for free. Be the first to read and do not miss future timely research publications.  

Inflationary pressures are becoming less transitory and more long-lasting. Even before the horrific events in Ukraine, inflation was already very high. Additional sanctions on Russia added additional fuel to the fire of already hot inflation. Sanctions on Russia will also have a significant negative economic effect on the world economy and particularly Europe. My heart and worry are with Ukrainians and everybody effected by the war. The world came together to punish Russia economically. However, it is not a one-party loss. Europe and the US will feel the pain from fighting an economic war with Russia. In addition, any resurgence of Covid-19 and potential new variants may further disrupt the supply chain and put pressure on both economic growth and higher inflation. The Federal Reserve found itself behind the curve in raising rates. In my opinion, the Fed may have to increase its short-term interest rate significantly and faster than many may have hoped for. Combination of all these factors makes the recession in the US and Europe more likely withing the next 12 months. 

Today’s world has two bipolar images of pain and suffering in Ukraine as one image and reopening of the economy in the US and Europe as the second image. It is difficult to comprehend that both images could coexist at the same time. Pent-up demand after the Covid-19 pandemic may drive prices higher. People are craving travel, going out, and experiences. The increase in the demand for travel will add upper pressure on energy prices. By going out to restaurants, watching shows, attending sporting events and concerts, the demand for food and labor may increase further. Greater demand for goods and services in combination with already tight labor market, may translate into higher wages. Employers may have to pay higher wages to attract employees. 

Low unemployment and strong economy may create a favorable environment for wage growth. The current labor market can be described as tight and near full employment. Unemployment rate has declined from 14.7% in April 2020 to 3.8% in March 2022 (see Chart 1 Unemployment Rate). When the labor market is tight, employers will have to raise wages to attract new employees. During periods of strong economic growth and increasing demand for goods and services, employers can pass the increase in labor cost to consumers. In some cases, prices may rise faster than the increase in wages. In this case, employees will demand another increase in salary. This chain reaction may continue to trigger additional increase in prices followed by higher wages. 

Possible further increase in oil prices may boost overall U.S. inflation. The Fed Chairman Jerome Powell said that $10-per-barrel increase in oil prices may increase the inflation by 0.2% in the US (WSJ Inflation). Crude oil has already increase by $40 since the beginning of 2022 which may have contributed to 0.8% increase in the overall inflation during the first two months in 2022. Russia has predicted the price of oil above $300 if the West bans energy imports (CNBC Russia). If we see oil prices rise above $300, the overall inflation may increase by more than 4% from 7.9% currently to 12% per year. 

The supply driven inflation may continue for longer than the Fed has expected. As the war in Ukraine continues, the economic sanctions on Russia may continue to escalate. Russia is a major supplier of nickel. The shortages of nickel may drive the cost and disruptions in the production of electrical vehicles and stainless steel. Nickel in used in the production of batteries and stainless steel. Russia is also a major exporter of oil, natural gas, coal and the world’s biggest exporter of wheat and fertilizer products. Ukraine is also one of the biggest exporters of wheat and agricultural products. As Europe and the US cannot buying commodities and agricultural products from Russia and Ukraine, the inflationary pressure will persist.

Another disruption in the supply chain can come in from China and its zero-tolerance policy for Covid-19 outbreaks. China shuts down factories and implements strict quarantine with each Covid-19 outbreak. Also, there is a possibility of a new variant to appear and disrupt the supply chain unexpectedly. 

The Federal Reserve has a dual mandate: maximum employment and stable prices. We are already near full employment (See Chart 1). The Fed should focus on its second goal now – stable prices. The most recent total CPI index increased by 7.9% over the last 12 months (see Chart 2). The biggest increases in prices over the last 12 months were in Fuel Oil 43%; used cars 41%; gasoline 38%; energy commodities 37%. The Fed has a long-term inflation target of 2%. By drawing the 2% inflation target next to the actual price changes over the last 12 months, you can clearly see a very significant spike in inflation and a wide deviation from the two percent target (see Chart 2.) 

The Fed was already behind the curve in raising interest rates. The inflationary pressures may accelerate further this year and remain long-lasting. On March 16th, the Fed raised its benchmark federal-funds rate by 25 bps to the range of 0.25%-0.50%. The Fed has also signaled six more increases by the end of the year (WSJ, Fed Raises Interest Rate.). The median projections by the Federal Reserve Board members is 1.9% by the end of 2022 and 2.8% by the year end 2023 (Board of Governors). In my opinion, the Fed may start raising interest rates faster than the consensus expectations. The Fed may consider even 50bps increases instead of tradition 25bps. As the President of the Federal Reserve Bank of St. Louis, James Bullard said that the Fed should raise rates faster or “risk squandering policy credibility” (WSJ, Fed Raises Interest Rates). This is what the stock market is not pricing in right now. The short-term yield is likely to go much higher this year. As the Fed pushes the short-term yields higher, the yield curve may start to flatten and even reverse at some point. 

As the Fed raises its short-term rates, the long-term rates may not move up in the same proportion. Investors may find long-term treasury bonds as an attractive hedge against a recession. As the Fed is trying to cool down high and increasing inflation by raising short-term interest rates and slowing down the economy, the Fed may over tighten. The current interest rate spread between 10-Year Treasury and 3-month Treasury is 1.80% as of March 17, 2022 (Chart 3). So, there is still plenty of room before the yield curve becomes inverted. However, with each increase in the short-term rates the yield curve may become flatter and finally invert in the near future. This may signal the risk of the economic recession and create the demand for long-term treasury bonds.   

An inverted yield curve has always been a strong predictor of the economic recessions in the US. It predicted economic recessions of 1990-1991; 2001; 2008-2009 and the most recent Covid-19 recession in 2020 (see Chart 3). Currently high and rising inflationary pressures, may cause the Fed to raise short-term rates significantly higher and above the long-term treasury yield. This will create an inverted yield curve, a strong indicator of a possible economic recession. 

In addition to high inflation and restrictive monetary policies, the sanctions against Russia and horrific events in Ukraine slow economic growth in Europe and the US. The sanctions against Russia will have a significant negative economic impact on Europe and even the US. This is the economic pain which Main Street will feel. Russia’s total export and import with non-CIS countries was at $700 billion in 2021 and $100 billion with CIS countries (see Chart 4). CIS countries include Azerbaijan, Armenia, Belarus, Kazakhstan, Kyrgyzstan, Moldova, Russia, Tajikistan, Turkmenistan, Uzbekistan and Ukraine. You can see the significant economic ties between Russia and the West. The production and movement of goods together with the banking system has a multiplier effect. The sanctions against Russia will both increase inflation and slowdown economic growth across the Europe and the US. 

As the forecast for the year 2022, I would expect high and long-lasting inflationary pressures to persist. The Fed may be more hawkish and willing to raise rates significantly to fight inflation and keep its credibility. The European Union and to a lesser degree the US economy will lose growth as a result of the economic fight with Russia. Zero tolerance policy against Covid-19 outbreaks in China will continue to disrupt the supply chain and put inflationary pressures. In combination, higher interest rates and lower economic growth increase a risk for the next recession. 

Disclosures: 

The analysis is based on historical data and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor, before making an investment decision. Neither ECNFIN.COM nor its author are responsible for any damages or losses arising from any use of this information. Past performance doesn’t guarantee future results.

ECNFIN.com and its podcast are not associated with nor do they necessarily represent the opinion or advice of Epiqwest Culver Wealth Advisors LLC.  

References:

BOARD OF GOVERNORS of the FEDERAL RESERVE SYSTEM. Retrieved on March 17, 2022. https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20220316.pdf

CNBC EUROPE NEWS. Russia warns of $300 oil, threatens to cut off European gas if West bans energy imports https://www.cnbc.com/2022/03/08/russia-warns-of-300-oil-if-ban-goes-ahead-threatens-to-cut-off-european-gas.html

Federal Reserve Bank of St. Louis, 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity [T10Y3M], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10Y3M, March 10, 2022.

Merchandise Trade of the Russian Federation, Bank of Russia. https://www.cbr.ru/eng/statistics/macro_itm/svs/ March 5, 2022

U.S. Bureau of Labor Statistics, Unemployment Rate [UNRATE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, March 9, 2022.

U.S. Bureau of Labor Statistics, Consumer Price Index Summary https://www.bls.gov/news.release/cpi.nr0.htm , March 10, 2022

WSJ. Inflation Reached 7.9% in February; Consumer Prices Are the Highest in 40 Years https://www.wsj.com/articles/us-inflation-consumer-price-index-february-2022-11646857681?mod=hp_lead_pos1&mod=hp_lead_pos1

WSJ. Fed Raises Interest Rates for First Time Since 2018. https://www.wsj.com/articles/fed-raises-interest-rates-for-first-time-since-2018-11647453603

Subscribe wherever you enjoy podcasts:

Our Mailing Address:

ECNFIN
1312 17th Street
Unit #2991
Denver, CO 80202

Our Fax:

+1 720-790-7606