Double-digit inflation is now quite plausible
The commodity price spike caused by the war in Ukraine has increased the risks of a recession, sustained high inflation, or both.
Between the lines: Just a couple of short weeks ago, the economic outlook seemed to be coming into focus. Supply crunches were starting to un-crunch. The Federal Reserve was starting monetary tightening, taking away the economy's pandemic-era training wheels. The private sector was booming anyway.
- The range of possibilities for what the economy looks like a year from now has widened considerably in just a few short days, in ways that leave policymakers with a higher degree of difficulty in trying to attain benign economic conditions.
The big picture: The latest Consumer Price Index numbers — 7.9% over the 12 months ended in February — show just how widely inflation pressures have spread over the last year. But there has been a plausible rosy story to tell about the outlook, at least until recently:
- Pandemic fiscal stimulus is done. The Federal Reserve will start raising interest rates next week, tightening financial conditions. Supply chain managers worldwide are starting to overcome logjams.
Now, things are more complicated. Prices are surging for energy and food commodities, and those are going to flow through to what American consumers must pay for staples over the months ahead.
- Price spikes in metals produced in Russia like palladium and nickel will filter out into U.S. inflation more slowly, as shortages of key materials amount to a new source of supply chain snarls for cars and other durable goods.
- It would have been simpler if the war-driven commodity price spike had happened a few years ago, when inflation was low and it would have been easy to chalk up a war-induced price spike as an aberration for policymakers to ignore.
What's next: Given shifts in commodity markets, it's pretty much a mathematical certainty that inflation rates will be higher in the months ahead rather than lower.
Will year-over-year headline inflation hit double digits? Quite plausibly. That leaves the Fed between a rock and a hard place.
- If the Fed accelerates its monetary tightening campaign, it would rock already-jittery financial markets and slow the labor market expansion at the same time Americans are feeling the pinch of higher prices. Depending on how entrenched inflationary behavior has become, it may even take a recession to break it.
- But conversely, if the Fed sticks to a slow, gradualist approach of rate hikes, it will make it that much more likely that high inflation becomes entrenched, eventually requiring an even more severe economic downturn to undo.
The bottom line: The gyrations in markets in recent days are only the beginning. The potential results for the economy involve some gloomy possibilities.