‘People are going to get real nervous’: Oil shock upends Fed strategy

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Russia’s invasion of Ukraine threatens to further disrupt global supply chains just as shipping delays were poised to improve, scrambling the economic outlook and the Federal Reserve’s strategy for fighting inflation along with it.

The Fed is set to begin hiking borrowing costs next week in a bid to rein in consumer prices, which the government said Thursday rose at the fastest pace in four decades. But central bank policymakers like Chair Jerome Powell had also voiced hope that supply shortages would soon begin to subside, helping them curb inflation without sharply restricting economic activity. Indeed, logistics experts were optimistic heading into March, with workers returning to the labor force and filling staffing gaps as the pandemic fades.

But Russia’s attack in late February sent oil prices surging some 25 percent over the following two weeks. Energy costs are expected to remain high, making the transportation of goods much more expensive. Shipping routes around the war-torn region must now be recalibrated, and more than 300,000 companies in the U.S. and Europe alone could see disruptions, one supply chain software CEO estimated.

Higher costs at the gas pump already contributed significantly to inflation in February, which rose at a blistering 0.8 percent rate from the previous month and 7.9 percent over the past year, the highest since 1982, according to consumer price index data released Thursday.

The Rubik’s cube of global trade adds another layer of complexity for the Fed, which will have to keep an eye on risks that inflation could speed up, even as the economy — which grew at a spectacular 7 percent annualized pace in the fourth quarter — is likely to take a hit from higher oil prices.

“There is no clear answer to how the Fed should respond because these forces are pulling in opposite directions,” said David Wilcox, former director of the Fed’s division of research and statistics. “The most important thing for them to do now is to communicate that the situation is incredibly uncertain.”

The war, which has already forced more than 2 million Ukrainians to flee their country, according to the United Nations, has led to a dire humanitarian crisis and reshaped global geopolitics. But the situation also poses clear economic dangers to President Joe Biden’s economy, most acutely from higher prices for oil and gas.

Tim Fiore, who oversees manufacturing surveys at the Institute for Supply Management that are considered benchmark indicators of the state of the economy, said he expects a jump in production as the number of available American workers increases. But rising energy costs might run headlong into that trend.

“I’ve been pretty confident that we’re not going to see [the pace of] price increases continue,” said Fiore, who is also a senior vice president at transportation and logistics company Ryder. “I’m not so sure now. With the energy prices going up the way they are, you know, people are going to get real nervous.”

Higher oil and gas prices could raise the costs of energy-intensive components like steel, cement and plastics that are used across industries. And transporting all manner of products will get more expensive with elevated fuel costs for ships and planes.

As oil prices go up, “you will have additional costs and there's a good chance that those get passed along to the people who are trying to ship the goods,” said Phil Levy, the chief economist at Flexport, a trade technology company, and a former White House trade economist under then-President George W. Bush.

In the wake of the deadly conflict, costs associated with Russian exports like aluminum have also skyrocketed, while the involvement of Ukraine, a big producer of commodities like corn and wheat, has fed worries about a global food crisis. Russia’s beleaguered neighbor is also the supplier for roughly half the world’s neon gas, which is used to manufacture semiconductors, an industry that is already experiencing serious shortages.

Further hits to supply chains will also weigh heavily on U.S. small businesses, which are bracing as gas prices increase, said Holly Wade, executive director of the National Federation of Independent Business’s research center.

“We just keep hearing from small business owners about the variety of cost increases they’re experiencing,” she said, adding that more than a quarter of small business owners cite inflation as their most important problem.

Assessing the impact on specific sectors presents a challenge for economists, said Levy. Most companies have multiple suppliers so other countries could fill the void created by the conflict. The length of the war matters, too, as stockpiles of vital goods may run out before exports resume.

For Fed policymakers, it’s unclear how all this will affect their decision-making. Economic growth is strong, and the labor market is adding jobs at a rapid clip, with a staggering 678,000 in February alone. That suggests the economy should be able to weather a temporary shock, said Julia Coronado, a former Fed economist and president of MacroPolicy Perspectives.

Also, higher gas prices could ultimately dampen inflation because they mean that consumers have less money to spend on everything else — and could even cut back on their driving to save costs.

“Typically, central banks look through such things because they usually act as a tax on consumers that affects demand, it affects willingness to hire, it slows the economy down more,” Coronado said. “But you’re starting from a point of very high inflation.”

“It’s going to be very hard for the Fed,” she added. “They’re going to keep going with their plan [to hike rates] because the economy is starting from such a strong starting point, but that strength isn’t assured.”

The U.S. will see fewer direct impacts than Europe, the Middle East or North Africa, said Matthew Hockenberry, a supply chain expert at Fordham University. But the cumulative effect could still bite.

“Train transportation from China that goes through Russia to Europe, it’s just gone,” he said. “There are little surprising things, like the number of Russian and Ukrainian crew members in the shipping industry is quite high. Those people are taken out of the equation.”

Fewer raw materials and higher energy costs will also hurt European manufacturing, which will feed back into the U.S., Hockenberry said.

“Even if those things are localized to some degree to Europe, that’s sort of a worldwide effect,” he said.

Wilcox, now an economist at the Peterson Institute for International Economics and Bloomberg Economics, said the U.S. economy’s dependence on foreign oil has eased in the years since the energy crises of the 1970s. The U.S. exports more oil and gas today than it did at that time, for instance, meaning Americans working in the industry benefit from price increases.

Still, the war in Ukraine sparked a rise in global oil prices that could go higher after the U.S. and U.K. governments announced plans to ban certain energy imports from Russia. In making the announcement, Biden warned consumers to gird their wallets and urged oil companies not to exploit the crisis with unfair price hikes.

“It is a really serious problem for lots of families, especially at the lower-income end of the income distribution, and there isn't going to be any relief here in the next couple of months,” said Wilcox.

Commerce Secretary Gina Raimondo told Yahoo Finance Live on Tuesday that the administration was helping industries that consume nickel, palladium and uranium to identify alternative sources, adding that “most companies have quite a lot of stockpile, so this isn’t an immediate problem.”

“It is hard to say how this makes inflation any less worrisome,” Levy said. “The question is whether it's going to get explained away as food and energy volatility, which it ought not to, or whether this gets taken into account and inflation concerns heighten.”