Russia-Ukraine War Complicates Fed’s Inflation Fight

Tougher choices seen in effort to douse inflation without triggering a downturn

Jerome H. Powell, Chair of the Board of Governors of the Federal Reserve

Pool / Pool / Getty Images

Russia’s invasion of Ukraine isn’t going to stop the Federal Reserve from raising interest rates at its next policy meeting in March, but it may slow the pace of the increases, if you believe what the markets are saying.

Key Takeaways

  • Russia’s invasion of Ukraine isn’t likely to stop the Federal Reserve from raising its benchmark interest rate at its March 15-16 policy meeting, but it does scramble the outlook for how much and how fast the Fed might move.
  • The central bank now has to balance the risk of even higher inflation from a protracted war if it moves too slowly, with the possibility of a sharp economic downturn—or even recession—if it moves too aggressively.
  • A tool that predicts the size and timing of rate hikes now favors a slower-moving Fed, and there will be intense interest in any clues Chair Jerome Powell might drop about the Fed’s intentions during his scheduled testimony to Congress this week.

As tensions between Russia and Ukraine escalated in February, with multiple warnings from the U.S. government that an invasion was imminent, investors were paring back their expectations for how aggressively the Fed might step in to curb inflation, already at 7.5% for the 12 months ending in January—a 40-year high.

The CME FedWatch Tool, which uses market sentiment to calculate the probability of a Fed rate move at upcoming policy meetings, showed that in mid-February, investors started consistently predicting a quarter point increase, instead of a half point, in the Fed’s benchmark interest rate at the central bank’s policy meeting on March 15-16.  

The benchmark rate, or fed funds rate, influences the rate on all sorts of loans, including those for credit cards, adjustable rate mortgages, and auto and home equity loans. At the onset of COVID-19, the Fed slashed the benchmark rate to near zero, making it easier for people to get cheap loans to help them through the pandemic. Now, with the economy and labor market growing robustly and inflation soaring, the Fed is eager to return to a more normal policy that includes higher interest rates.

The Russia-Ukraine conflict, however, has created new uncertainty the Fed will have to take into account when deciding how much and how fast to raise rates, analysts say. It has also further heightened interest in clues about the central bank’s intentions that might be gleaned from Fed Chair Jerome Powell’s scheduled testimony before Congress on Wednesday and Thursday.

If the situation with Russia worsens and western countries are forced to enact the toughest sanctions—cutting off supplies of major commodities, including oil and gas, for example—the U.S. risks a sharp economic slowdown or even recession if the Fed raises rates too aggressively, analysts believe. On the other hand, if the central bank is too lax about increasing rates, inflation could continue spiraling upward, crimping the economy and consumers—especially lower-income households struggling to make ends meet.

In the worst-case scenario, the economy could experience stagflation—a period of low or negative growth accompanied by high inflation. 

“Fed officials have sometimes preferred to delay major policy decisions until uncertainty surrounding geopolitical risks diminished, including during the Kosovo war, the US invasion of Iraq, and the Arab Spring,” Goldman Sachs economists wrote in a recent commentary. “In some cases, such as after September 11 or during the US-China trade war, the FOMC cut the funds rate modestly. The current situation is different from past episodes when geopolitical events led the Fed to delay tightening or ease because inflation risk has created a stronger and more urgent reason to tighten today than existed in past episodes.”

Fed Has Shown ‘Willingness To Be Flexible’

The CME FedWatch Tool showed on Tuesday that the probability of the Fed lifting its benchmark rate by 0.25% at its March meeting was around 98%—a sea change from Feb. 10, when the January inflation report came out and almost 94% expected an increase of 0.50%. President Joe Biden reportedly told allies that Russia could invade Ukraine on Feb. 16 (although the actual invasion didn’t happen until more than a week later).

Global stock markets initially tumbled and oil prices surged on news of the invasion on Feb. 24, but markets bounced back fairly quickly after initial rounds of western sanctions didn’t appear to be as harsh as they might have been. Then, over the weekend, countries around the world imposed new restrictions on the SWIFT financial network—a global payments system connecting international banks and facilitating cross-border financial transfers—that were intended to choke off Russia’s ability to tap its international funds, and Germany increased its defense budget in response to the invasion.

Although still tougher sanctions—a possibility if Russia widens its fight to include member-countries in the North Atlantic Treaty Organization—undoubtedly would hurt Russia, they could also depress western economic growth and damage global stock markets. 

Russia is a major producer of many commodities—including palladium, used for such things as catalytic converters, and aluminum, used in cans and airplane parts—but, most notably, oil. If these or other commodities face a supply disruption due to sanctions on Russian exports, their prices will spike. Much higher oil costs would be particularly worrisome because they would show up in gasoline prices and have broad inflationary implications for consumers.

While energy sanctions against Russia have not yet materialized, White House spokeswoman Jen Psaki said in an interview Sunday that sanctions on Russian energy remain on the table.

The Fed may be worrying about the hits global markets could take from the war, which makes the case for a more cautious and slower moving Fed, some economists say.

“There’s an argument that the Fed could go aggressively to battle inflation, but the Fed has signaled a willingness to be flexible,” said James Knightley, chief international economist at ING.

Knightley, who expects the Fed to increase rates only by a quarter point this month, said that higher interest rates are intended to dampen demand, not to halt rising oil prices or unsnarl supply chains that have been contributing to inflation. Some of that has already been happening anyway in anticipation of higher fed funds rates, he said, noting that mortgage rates have shot up to about 4% and caused a plunge in home purchase applications.

The Case for Aggressive Rate Hikes

Others, however, aren’t as convinced the Fed’s course should be slow and steady. 

“The hill the Fed has to climb is so big, they have to start immediately,” said Joe Carson, former  chief economist and director of global economic research for Alliance Bernstein.

Carson, who believes consumer inflation could reach 8% in the U.S. as commodity prices rise, said the Fed is misreading two things: The inflation cycle is much broader and more durable than the central bank thinks, and the Fed wrongly believes that people’s inflation expectations are “anchored” when, in reality, they’re not.

Already, there are signs that consumer expectations about future inflation in fact are rising. The Dallas Fed’s so-called “trimmed mean” personal consumption expenditures rate—an alternative inflation measure the Fed watches closely that filters out certain extreme price movements—has been moving up, for example.

For the 12 months ending in January, the measure was 3.5%—the highest since February 1991—while the one-month annualized rate was 6.7%, up from 4.6% the prior month and the fastest increase since July 1982. Both are well above the Fed’s 2% inflation goal over time.

Some Fed members have been advocating for aggressive rate hikes to tamp down inflation. Less than two weeks ago, St. Louis Fed President Jim Bullard reiterated that he’d like to see the Fed raise the fed funds rate by a full percentage point by July 1. With just three policy meetings scheduled before then, that likely means at least one rate increase would have to be at least a half point.

And, just last week, Fed governors Michelle Bowman and Christopher Waller suggested they were open to considering a half-point rate hike in March. 

But whether that will end up the majority opinion among policymakers at the Fed’s next meeting is uncertain. While San Francisco Fed President Mary Daly said last week she favors a rate hike at the March meeting, for example, she appeared to be more open to a slow and steady course, and Kansas City Fed President Esther George said in a recent Wall Street Journal interview that she prefers a “gradual” approach to rate increases. 

Given the pattern that Carson has seen from the Fed so far, he said he wouldn’t be surprised if, in the end, the Fed took the slow route to reining in inflation. 

“Given this current generation of policymakers, they will go late and go small,” he said. “They’ll look for an excuse to do nothing.” 

That means the Fed will likely allow inflation to keep running hot so as not to destabilize the markets and the economy, he said.

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  2. United States Congress Joint Economic Committee. "How Inflation Is Weakening the Recovery and Harming Low-Income Americans the Most."

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