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How has the war in Ukraine impacted the outlook for interest rate increases in the US? In this Macro Flash Note, EFG Chief economist Stefan Gerlach looks at how market expectations have evolved.
How has the war in Ukraine impacted the outlook for interest rate increases in the US? In this Macro Flash Note, EFG Chief economist Stefan Gerlach looks at how market expectations have evolved.
The war in Ukraine will have two offsetting effects on the economy and will therefore complicate the setting of monetary policy. First, the war will push up energy prices, and most likely also food prices, boosting inflation across the world. While this price-level shock will cause inflation to rise only temporarily (but for at least 12 months until it drops out of the year-over-year calculation), central banks will be concerned about the possibility of inflation remaining elevated or rising even higher. That would encourage central banks to tighten monetary policy more rapidly than otherwise.
Secondly, however, higher prices will negatively impact consumers’ spending power and raise production costs for firms, slowing the economy. To mitigate these effects, more expansionary monetary policy would normally be warranted.
Of course, how central banks should respond depends on the extent to which prices are pushed up by these developments and for how long prices will stay high. This is unclear at present. Central banks will therefore do little in the near term, focusing on understanding the incoming macroeconomic data and assessing how the global inflation and business cycle outlook has changed. It is unlikely that they will adopt any new monetary policy initiatives before they have completed this assessment.
The figure below shows how market expectations regarding the outcome of the March FOMC meeting have evolved since the beginning of January. These probabilities are calculated by the Chicago Mercantile Exchange, using prices of various financial instruments. On 3 January markets were pricing in a 39% probability that there would be no change in interest rates in March, a 57% probability to the Fed raising interest rates by 25 basis points and a four percent probability that the Fed would raise interest rates by 50 basis points.
By the beginning of February markets had come to expect tighter monetary policy, attaching a 92% probability to the Fed raising interest rates by 25 basis points and an 8% probability that the Fed would raise interest rates by 50 basis points. As inflation continued to rise, markets started to price in more rapid Fed tightening. By 14 February, markets attached a 39% probability to the Fed raising interest rates by 25 basis points and a 61% probability to the Fed raising them by 50 basis points.
The war in Ukraine has encouraged market participants to revise down their outlook for US monetary policy. By the time of the last observation, which is for 25 February, market participants attached a 76% probability of a 25 basis point federal funds rate increase at the March FOMC meeting and a 24% probability of an increase of 50 basis points.
Source: Chicago Mercantile Exchange, data as of 26 February 2022.
Interestingly, and as shown in the graph below, looking at market expectations for the outcome of the December 2022 FOMC meeting there is much less evidence of recent change in market expectations. This suggests that the war in Ukraine is not expected to impact Fed policy at that horizon.
Source: Chicago Mercantile Exchange, data as of 26 February 2022.
In brief, the war in Ukraine has led market participants to scale back their expectations of the Fed raising interest rates at its meeting in March but has had little effect on expectations regarding the outcome of the December meeting.
Figure 3 summarises market pricing for the March and December meetings. Thus, in March markets attach about 3/4 probability of a 25 basis point increase and 1/4 probability to a 50 basis point increase.
For December, the market is pricing in a federal funds rate in the range of 1.50-1.75, that is, six 25 basis points increases from today. That said, the market appears to attach a 31% probability to seven increases.
Source: EFG calculations on data from Chicago Mercantile Exchange, data as of 26 February 2022.
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