The U.S. economy faces mounting threats from abroad as the war in Ukraine and a COVID-19 surge in China threaten to stoke inflation and slow growth.
While most economists say the U.S. is still on track for stellar job gains and sturdy economic growth this year, the risks of a slowdown have spiked over the past two weeks.
The war in Ukraine and the weeks of rising threats from Russia have already driven crude oil prices – and the gasoline prices linked to them – to staggering heights. Energy and food prices, which had risen steadily throughout 2021, are on track to rise even higher as Russia’s invasion threatens the global supply of oil, natural gas and wheat.
Soaring COVID-19 cases across China could now add fuel to the inflationary fire as factories, neighborhoods and entire cities shut down under the country’s strict coronavirus containment policies.
“If you have more disruptions to Chinese factories and imports, more supply chain bottlenecks, more shortages, higher prices, this adds to the inflationary pressures,” said Mark Zandi, chief economist at Moody’s Analytics, in a Monday interview.
“It’s just one more reason to be nervous about the economy’s prospects,” he said.
Prices rose 7.9 percent over the 12 months ending February, according to the Labor Department’s consumer price index (CPI), the fastest annual inflation rate since January 1982. Monthly inflation also rose, pushing prices 0.8 percent higher last month alone, with food, gas and shelter prices leading the way.
Higher gas prices are also particularly challenging for consumers since they raise transportation costs for other goods and may not be avoidable for those who drive long distances for work.
Zandi, like most economists, said it’s too soon to know the full net effect on inflation of the war in Ukraine and COVID-19 outbreaks in China. But the higher inflation goes, the harder it could be for the Federal Reserve to tame it without derailing an otherwise strong U.S. economy.
The Fed is almost certain to raise interest rates Wednesday at the conclusion of the Federal Open Market Committee meeting set to begin Tuesday. Fed Chairman Jerome Powell told lawmakers last week the bank was on track to hike rates as inflation continued to rise far higher and faster than it expected.
“It’s just taking so much longer for the supply side to heal than we thought,” Powell told members of the Senate Banking Committee. “There really is no precedent for this.”
The Fed’s primary mechanism for fighting inflation is raising its baseline interest rate range, which drives borrowing costs for consumers and businesses. When the Fed wants to slow inflation, it will raise interest rates to cool off the pace of economic activity. For the same reason, the Fed will cut interest rates when the bank wants to stimulate the economy.
Powell expressed confidence last week the Fed could raise interest rates and cool off the economy without interrupting strong job growth – a delicate balance Fed watchers call “a soft landing.”
But economists fear the war in Ukraine and rising COVID-19 cases in Asia could push inflation too high for the Fed to cool it without causing a recession. And while Fed rate hikes could tamp down on some of the consumer demand pushing prices higher, they will do little to help unsnarl supply chains, clear port bottlenecks, tap more oil, grow more wheat or any of the wide-ranging supply shocks behind inflation.
“If we have inflation caused by aggregate demand – that means there’s too much spending in the economy – then the Fed definitely has control over that that can definitely bring that in,” said David Beckworth, senior research fellow at George Mason University’s Mercatus Center.
Beckworth said the Fed hiking interest rates could also exacerbate supply shocks as companies who are already struggling to produce face the toll of higher borrowing costs. That dynamic creates a difficult balance for the Fed: raise interest rates slow enough to allow the economy to recover from supply shocks, but fast enough to prove to markets that it can tamp down on inflation.
“One could make an argument that supply shock after supply shock after supply shock with extra demand in 2021 could put us on the path where finally inflation expectations are permanently unmoored,” Beckworth said.
“If that’s the case, then the Fed has to respond, even if it’s supply-side shocks.”
The Fed measures how high investors, consumers and businesses expect inflation to rise, known as “inflation expectations,” as a key gauge of future price increase. When inflation expectations rise steadily year after year, inflation itself can rise beyond the Fed’s ability to easily control it.
Under former Fed Chairman Paul Volcker, the bank pushed the U.S. economy into deep recessions to fight double-digit inflation after decades of rising expectations. The oil shock of the 1970s was one of several factors behind the steady spike in prices, though the U.S. faces far fewer threats from the energy sector now than during the Volcker years.
The U.S. is a net exporter of energy, meaning the additional consumer spending on energy will largely stay within the domestic economy. The U.S. is also heading into the squeeze after adding more than 1 million jobs in the first two months of 2022 and months of steady consumer spending.
“Higher oil prices still hurt us,” said Zandi of Moody’s. “But they don’t hurt us nearly to the degree they did at times past.”