All eyes have been on the U.S. Federal Reserve for months as investors await the central bank's move to slow or halt inflation. However, the focus has now shifted to the potential war that could erupt between Russia and Ukraine, a situation that the Fed is also watching.
Russia has officially invaded Ukraine, which pushed oil prices above $100 a barrel, putting the squeeze on your pocketbook. The gold price topped $1,050 an ounce, creating a setup for potential $2,000 gold.
Typically, the Fed targets an inflation rate of 2%, but it has run far ahead of that target, reaching 7% in December and 7.5% in January, its highest level in decades. Many market watchers are now pricing in a Fed policy mistake, and views differ on whether a mistake is about to be made or has already been made.
The Fed was widely expected to start its rate-hiking cycle in March, but the situation involving Ukraine and Russia greatly complicates matters.
Rising oil prices
Commodity prices have surged since Russia entered two separatist areas in eastern Ukraine. Oil and gas, in particular, are leading commodity prices higher in the wake of increasing tensions in that part of the world. Gas is a major purchase for most Americans, and the consumer drives approximately 70% of the U.S. economy.
Oil prices and the prices of other commodities have shifted higher amid concerns about Russian President Vladimir Putin's decision to move troops into Ukraine. In response to Moscow's provocative moves, the U.S. and its allies have started to sanction Russia, which could tighten oil and gas supplies further.
Russia is the second-largest producer of oil and natural gas in the world. It is also the world's largest wheat and palladium exporter and a major player in the market for metals such as nickel and aluminum.
However, Mark Zandi of Moody's Analytics told CNBC that it's the oil that will complicate matters for the world more than wheat and metals. He estimates that oil prices have increased by about $10 or $15 per barrel because of the conflict with Ukraine, and if it lasts, gas prices could rise by 30 to 40 cents per gallon.
Rising oil will boost inflation further
In turn, that could add a half-percentage point to inflation on a year-over-year basis, and the U.S. is already at a 7.5% increase in inflation. Zandi noted that the Russia-Ukraine conflict throws a major wrench into the Fed's attempts to bring inflation under control and return to full employment.
Crude prices rallied further on Wednesday following reports that the Biden administration expects a Russian invasion of Ukraine within the next two days. By Thursday, that invasion had happened. Moya of OANDA said in an email on Wednesday that the situation in Ukraine is advancing faster than anyone expected.
"The Ukraine situation seems to be heading towards a pivotal moment a lot sooner than everyone was hoping for, and that means oil prices could surge here," Moya warned in an email on Wednesday. "An immediate run towards $100 oil is still in the cards, but the rising prospects that an Iran nuclear deal could be reached in the coming days may tentatively delay a breaking of the century mark."
Since his email, oil reached $105 a barrel, paving the way toward soaring gas prices. Moya expects WTI crude to hold steady in the low $90 range until a major update on the Iran nuclear deal talks or if the new Cold War results in a military conflict.
"Even if an Iran nuclear deal is reached, it will take months to ramp up output, so even if oil drops 5%, energy traders will likely buy into that weakness," Moya added.
Crude prices are up by about 50% over the last 12 months, driving a 90-cent increase in the average gas price in the U.S. over the same period. Economists believe the oil price could end up driving Fed policy. Rising oil prices initially drive inflation higher and could end up triggering disinflation if they keep increasing, weighing on economic growth. In fact, oil prices could climb significantly higher now that Russia has launched a full-scale assault on Ukraine.
Gold also jumped following the Russian invasion of Ukraine, alongside palladium. According to Reuters, gold is now up by more than 7% year to date. Analyst Ole Hansen of Saxo Bank noted that there is safe-haven demand for gold and that the Ukraine crisis is "very inflationary because it's adding upward pressure on commodities prices."
Gold is a well-known hedge against inflation, and UBS analyst Giovanni Staunovo told Reuters that a protracted escalation of the tensions between Russia and Ukraine could lead to $2,000 gold.
How much will the Fed hike rates?
While most economists still expect an interest rate hike in March, expectations regarding the size of that hike vary. JPMorgan Chief Economist Bruce Kasman told CNBC that he expects the Fed to raise rates by a quarter of a point in March as the Ukraine situation weakens the argument for a half-point increase.
He looks for six additional rate hikes throughout the rest of the year. According to Reuters, the money markets are pricing in a 34.5% probability of a March rate hike of 50 basis points, down from recent probabilities of about 60%.
On one hand, the Fed could restrain its rate hiking in the event of an economic growth scare, resulting in fewer, smaller hikes. On the other, inflation could continue to soar despite the economic slowdown, and the central bank could respond with even greater aggression. Kasman believes $120 to $150 oil will cause enough damage to negatively impact global growth and points out that the Fed doesn't typically raise rates when oil prices are moving significantly higher.
Zandi sees the Fed focusing on controlling inflation, which is running much hotter and lasting much longer than it initially expected. He sees $150 oil as less likely and more indicative of a "dark scenario," although he pointed out that surging fuel prices could still capture the Fed's attention.
Zandi believes the Fed is more focused on inflation than on impacts to growth, adding that the pandemic was more of a supply shock, and the next layer is another oil-price shock. He noted that two major supply shocks are hitting simultaneously, which is why things are getting so difficult for the Fed.
A policy mistake could trigger a recession
Nancy Davis of Quadratic Capital Management told Reuters that the market is pricing in a policy mistake by the Fed and expects the central bank's interest rate hiking to push the economy into a recession.
While it seems clear that the escalating tensions between Russia and Ukraine have increased uncertainty in the market, Fox Business suggests that those tensions could enable the Fed to engineer a soft landing and avoid a recession. JPMorgan strategist Dubravko Lakos-Bujas said in a note this week that the Fed could make a policy error if it is overly restrictive with its monetary policy, especially if the business cycle keeps deteriorating.
However, the Ukraine crisis could force the Fed to reassess its tightening plans, causing it and other central banks to become less hawkish as policies consider fresh fiscal stimulus. Essentially, the Ukraine crisis could increase inflation further while crimping global growth, so the Fed will have to try to rein in inflation without triggering a recession. Many market watchers don't think it can do that.
Related: Gold Has Performed Well In Past Four Fed Rate Hike Cycles