The Federal Reserve’s Ukraine challenge

John Maynard Keynes famously said “When the facts change, I change my mind. What do you do, sir?” If ever the economic facts have changed, it must be today in the wake of Russia’s invasion of Ukraine. This invasion highly complicates the Federal Reserve’s policy choice at its next meeting on March 15-16 as to what to do to bring inflation under control without bursting the U.S. equity and housing market bubbles.

Even before the Russian invasion, the Fed’s past policy mistakes put it in a very difficult situation. The maintenance of an ultra-easy monetary policy stance, at a time when the economy was recovering strongly and receiving its largest peacetime budget stimulus on record, caused inflation to surge to a 40-year high. At the same time, by continuing to buy massive amounts of U.S. Treasury bonds and mortgage-backed securities at a time when the U.S. equity and housing markets were on fire, the Fed created bubble-like conditions in the equity and housing markets.

This combination of high inflation and high asset price inflation had put the Fed in an acute policy dilemma before the Russia-Ukraine crisis. If it failed to raise interest rates aggressively now, it risked allowing both inflation expectations to become entrenched and further froth to be added to already bubbly asset and credit markets. That in turn would set the U.S. up for an even harder economic landing down the road than if it now acted in a timely manner.

On the other hand, if it were to raise interest rates aggressively, it might succeed in getting the inflation genie back into the bottle but at the price of bursting today’s “everything” asset-price and credit-market bubble.

Russia’s Ukraine invasion now makes the Fed’s policy dilemma all the more acute. It does so by both adding to our current inflationary pressures and heightening the chances that our asset and credit market bubbles will soon burst as a result of heightened geopolitical uncertainty. 

The main way that the Russian invasion adds to our inflation problem is by threatening the world’s supply of energy, food and a select group of metals such as platinum and palladium, where Russia dominates world markets. Not only is Russia one of the world’s major oil and natural gas producers, supplying Europe with around 40 percent of its natural gas needs. Russia together with Ukraine account for 25 percent of the world’s wheat exports. 

Since the start of the year, oil prices have increased by some 30 percent and grain prices by some 15 percent. With an early resolution of the Russia-Ukrainian crisis unlikely, consumer price inflation will rise from its present already-high rate of 7.5 percent and remain high for some time. That in turn could cause inflation expectations to become unanchored. This might explain why most economic forecasters are now predicting that inflation will remain at least twice as high as the Fed’s 2 percent inflation target by the end of 2022.

The more than 10 percent decline in U.S. equity prices since the start of the year underlines the risk that the Russian crisis poses to the potential bursting of today’s asset and credit market bubbles. Should this crisis continue to cast a dark cloud over the world economic recovery, it would not take much of a rise in Fed interest rates to burst our asset price and credit market bubbles.

The Fed should never have allowed itself to get into its current policy dilemma. It did so by keeping interest rates too low for too long in the face of rising inflation at the same time that it was buying too many bonds for too long in the face of booming equity and housing market prices. Last year, had the Fed been less complacent about inflation and asset price inflation risks, maybe then we would not have been as vulnerable as we are today to having the Russian-Ukrainian crisis help precipitate a hard economic landing.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.