Will the Ukraine crisis keep the Fed in limbo?
Remaking of the Fed’s board and rate hikes could be in flux.
Russia’s unjustified and unprovoked invasion last Thursday left many Ukrainians dead or injured in numbers sure to rise. According to Pentagon estimates, Europe’s seventh-largest country (at 44 million) may see as many as five million Ukrainians eventually displaced.
Financial markets greeted this shocking news with a predictably negative knee-jerk response: the VIX (volatility index) spiked to 38; benchmark 10-year Treasury yields plunged to 1.85% in a massive flight-to-safety rally; the yield-curve spread between two-year and 10-year Treasuries narrowed to less than 40 basis points, implying a greater risk of recession; gold soared to $1,974 per troy ounce as a store of value; crude oil (West Texas Intermediate, or WTI) leapt to $100 per barrel; and stocks plummeted 2-3% at Thursday morning’s open, depending on the index.
How will the Fed respond to this stagflationary shock? We have no idea, of course, as to the outcome of Russia’s military incursion or the near-term direction of these highly volatile financial-market metrics. The Federal Reserve will host its critically important FOMC meeting on March 16, at which time it is expected to complete its bond-buying taper, hike interest rates by a quarter point and lay the groundwork for shrinking its $9 trillion balance sheet. Nominal CPI inflation already is running at a 40-year high of 7.5% in January. Crude oil prices have tripled over the past 15 months and gasoline prices have risen 69% to $3.57 per gallon. Clearly the Fed needs to raise interest rates to cool inflation.
Remaking the Fed’s Board of Governors President Biden’s five nominees to remake the board are in a logjam, as the Chairman of the Senate Banking Committee, Sen. Sherrod Brown (D-Ohio), has insisted that they receive a single up-or-down committee vote as one block. The subcommittee likes the renomination of Chair Jerome Powell for a second term, the promotion of existing governor Lael Brainard to vice chair, and the nomination of Philip Jefferson as an at-large board member. Powell’s term expired last month, and he has been granted Chair Pro Tempore powers to continue to lead the Fed until the Senate formally decides on his fate. But there is disagreement about Sarah Bloom-Raskin as vice chair of banking supervision and Lisa Cook as an at-large board member. Some of the concerns relate to the Fed’s dual mandate, which studies the Phillips’ Curve tradeoff between inflation and unemployment. Raskin and Cook believe the Fed should expand that to include considerations such as climate change, which is a critical issue in the context of the current Russian energy debate.
The solution, in our view, is for Sen. Brown to break this group of five apart to receive individual votes on each of their candidacies. If Raskin and Cook should fail to receive enough votes, then President Biden will simply nominate replacements. But we shouldn’t hold up the nomination of three acceptable candidates ahead of such an important FOMC meeting.
Russian hegemony Condoleezza Rice (President George W. Bush’s national security advisor and Secretary of State from 2001-2009) once explained that it was Russian President Vladimir Putin’s long-standing objective to reconstruct the former Soviet Union. So his desire to attack Ukraine before it becomes a NATO ally and install a Russian puppet government should have been well known to the intelligence community. In fact, it appears that Putin has been preparing for this moment for at least a decade, both militarily and economically. For the latter, he has raised cash, shed U.S. Treasuries and prepared to withstand global sanctions. Why did Putin choose to pull the trigger now? He may have wanted to wait until the Beijing Olympics had completed, and calculated that the world remains focused on Covid and the U.S. is distracted by our southern border crisis and our disastrous withdrawal from Afghanistan.
Sanctions underwhelming While there’s understandably little appetite to place U.S. boots on the ground in Ukraine in a shooting war, we’re underwhelmed by the sanctions announced by the Biden administration. They clearly were not an effective deterrent to prevent Russia from invading Ukraine, and we doubt they will severely enough punish Putin to prevent him from considering an encore performance somewhere else in eastern Europe.
Plan B So what to do instead? We need to demonstrate global leadership and hit Russia where it hurts:
- Ban more Russian banks from participating in the SWIFT (Society for Worldwide Interbank Financial Telecommunications) global payment system.
- Sanction Russia from selling oil and gas to Europe and the U.S.; Europe gets 40% of its natural gas from Russia (55% for Germany), while the U.S. imports 700,000 barrels per day of crude oil from Russia, which accounts for 4% of our daily consumption.
- Fill that energy supply gap both here and abroad by becoming the energy seller of last resort.
In 2020, we were the largest energy producer in the world at 13 million barrels per day, surpassing both Saudi Arabia (9 million) and Russia (10 million). But because of the Biden administration’s climate polices (bans on the Keystone XL pipeline, drilling in Alaska, fracking on federal lands and offshore drilling, and an accelerated transition to electric vehicles), our production has fallen 15% to 11 million barrels. We need to encourage more exploration & production activity here to get back to 13 million and eventually to 15 million, to prioritize our energy self-sufficiency and to fill the energy void in Europe, breaking the collective dependency on Russia.