The Dilemma of the Fed and Other Major Central Banks in the Face of the Ukraine-Russia War

A difficult balancing act awaits Jerome Powell and the other central bankers in the months to come.

It has been more than ten days since the war between Ukraine and Russia started. If you live in the Western world, your news channels are constantly broadcasting images of this war. Military experts, geopolitical specialists, and economists are on the air, feeding their ideas to debates that are trying to explain what is at stake in this war between Ukraine and Russia, but also what the immediate and medium/long term consequences will be.

We are clearly in the middle of a propaganda war and it is difficult to know what the reality is. On the one hand, you hear the Ukrainians giving a figure for the losses of the Russian army. On the other hand, you hear the Russians giving a figure about the Ukrainian losses and the progression of the Russian army.

It is difficult to know what the real forces on the ground are, even if we can assume that the Russian army is advancing day by day. The Pentagon estimates that 80% of the 150,000 Russian troops mobilized for this operation in Ukraine are on Ukrainian territory. However, the Russian advance seems to be slowed down by logistical problems.

The war between Ukraine and Russia will have major consequences on the economy

Such a war at the gates of Europe has major consequences on the economy. The price of oil and other commodities continues to soar. The Fed and the other central banks of the world's major economic powers are going to find themselves up against a wall.

This war in Ukraine will have two major consequences on the world economy, and in particular on the European economy:

1. Economic growth will slow down sharply.

2. Inflation will rise from an already high level.

Economists are now openly talking about the risk of stagflation: the combination of zero economic growth and high inflation. In America, the spectre of the severe stagflation of the 1970s is beginning to resurface. However, we are still far from it, as economic growth remains strong due to the post-COVID catch-up effect.

Just when it seemed that the COVID crisis would end, a new crisis arises with the war between Ukraine and Russia. Faced with the risk of economic slowdown and rising inflation, central banks will have to choose their battle.

Central banks like the Fed will either have to worry about growth, in which case they will not raise their interest rates as expected by the markets. Or central banks will focus on the slippage of inflation, in which case they will raise interest rates more quickly and more sharply. This is a real dilemma for the Fed and other central banks, as these are two radically opposed choices.

Stepping back, we can say that in the current situation, there is a risk on the one hand and a certainty on the other.

Central banks will be faced with a major risk and a more than risky certainty

The economic slowdown due to the war between Ukraine and Russia is still only a risk. It is indeed difficult to assess at this stage the impact of the war in Ukraine on the world economy. On the other hand, the slippage of inflation is a certainty. Inflation reached a 40-year high in America in January 2022.

The February 2022 numbers will come out this week, and they will be scrutinized by all investors. Oil rose again. Brent and crude are close to $120:

Gas is also soaring.

The battle against inflation, which promised to be the major issue at the beginning of the year, will be even harder to fight. Inflation will accelerate sharply because of the war in Ukraine. This inflation is likely to cause an economic slowdown of the economy by impacting the purchasing power of households and therefore the consumption and margins of companies.

The Fed and other central banks will have to play a delicate balancing act

If you understand my reasoning, you understand why the Fed and other central banks will have to continue to make inflation their priority in the months to come. Inflation will be a priority, but it will have to be done more cautiously to account for the economic slowdown. This means that the steering of monetary policy will become even more complex in the coming months.

We have already had the perfect illustration of the balancing act that central bankers will have to play in the coming months with Jerome Powell last week. Jerome Powell, the head of the Fed, confirmed that the Fed would indeed raise rates in March 2022 as long expected by the markets. But, because there is always a but with Jerome Powell, this rate hike should probably be “only” 0.25% while everyone was expecting 0.50% for this increase.

This illustrates that if central banks are indeed tackling inflation, they face a real dilemma, as they have to do so without breaking economic growth.