Capital Ideas^TM

Russia’s military aggression against Ukraine, which has become Europe’s largest ground war in generations, has impacted millions of people and triggered a large-scale humanitarian crisis as vulnerable Ukrainians take shelter or flee their homes. The intensification and spread of the conflict is deeply troubling and is having a devastating impact on those people caught in the crisis.

This article focuses on potential market and economic implications of the conflict.

While the threat to Europe’s economy is far greater, the U.S. economy probably won’t emerge from this conflict unscathed. Rising energy prices were a problem prior to the invasion of Ukraine, and now are moving higher as global markets contemplate a world without Russia’s vast oil and gas supplies.

That could very well lead to higher U.S. inflation, which is already running hot. Price increases for food, energy, and other goods and services essentially rob U.S. consumers of their purchasing power. That can put a damper on consumer spending, which accounts for about 70% of U.S. economic activity.

Could it be bad enough to push the U.S. into recession? I’d put the chances at 25%–30% by late 2022 or early 2023. The R word is a much bigger issue for Europe, of course, because of its proximity to the crisis and dependence on Russian trade, particularly in the energy sector. Europe is more exposed than the U.S., but both economies could falter if the conflict isn’t resolved soon.

With the Fed poised to raise interest rates later this month, some market participants are wondering if the Ukraine crisis might give Fed officials a reason to keep rates near zero. I don’t see it happening.

The Fed is in a tough spot. With U.S. inflation hitting a 40-year high of 7.5% in January — and a war-related energy shock potentially pushing it even higher — Fed officials have no choice in my view but to raise rates at their March 15–16 meeting. In an ideal world, they could pause. But at this level of inflation, I don’t believe they have the luxury. That said, the conflict probably means a hike of 50 basis points is off the table. Rather, a more moderate increase of 25 basis points is likely.

Fed officials have clearly telegraphed their intention to tighten monetary policy. Investors should expect them to do so.