Although a world away, American citizens are feeling the punishing effects of the global economic sanctions against Russia. Inflation has continued to soar in the last month, according to federal data released in February. In the past few months, prices for fuel, food, rent, and other goods surged due to pandemic labor shortages and supply-chain bottlenecks.
Even prior to the Russian invasion of Ukraine on Feb. 24, the data over the last two months heightened concerns about rising inflation. Analysts are warning that Russia’s invasion of Ukraine will likely drive costs even higher.
Nikolai Roussanov, professor of finance at Wharton School, talks to Penn Today about the economic impact of the war, inflation, and energy.
How will the Ukraine crisis affect inflation in the U.S. in the coming months?
We are coming into this new crisis with historically high inflation rates, not seen since the early 1980s. In February, the CPI [Consumer Price Index] inflation rate was 7.9% at annual rate (or relative to 12 months prior), but also revealing are its components. Economists often differentiate between food and energy prices, which are very volatile, and the rest of the CPI basket (also known as core inflation), which is smoother but also more persistent.
We saw the same rate for food as the headline number (7.9%), a 25% increase in the price of energy goods, which had come down, as it was running higher, as high as 50%, in earlier months, and a record high rate of core inflation, which has been creeping up steadily over the last year and reached 6.4% in February.
We should remember that over much of the last year, Fed Chair Jay Powell argued that the bout of inflation is transitory and would abate as soon as the economy shakes off COVID, and the supply chain issues that have caused it would resolve themselves.
Against this backdrop, the war in Ukraine looks likely to maintain, if not accelerate, this trend in inflation, making it even less likely that it would revert to its extremely low pre-COVID levels. We have seen large movements in commodity markets, which will directly impact food and energy prices, but also some of the ‘core’ components.
Energy is the most widely discussed due to the restrictions placed on oil and natural gas imports from Russia, but global food prices are also likely to rise. Russia and Ukraine are both major exporters of agricultural commodities, between the two of them supplying the majority of grain, such as wheat, that is consumed in some countries, like in the Middle East. Since these are globally traded commodities, they are likely to experience price increases even in places, such as the U.S., that do not directly depend on the Russian or Ukrainian imports. Wheat futures spiked earlier this month as Ukrainian ports on the Black Sea were being blocked or taken over by the Russian forces, settling at levels about 50% higher than one month ago.
Beyond food and energy prices, core inflation might also be affected, since both countries are major exporters of industrial materials, such as steel, and Russia dominates some of the non-ferrous metal markets, from aluminum to nickel to palladium, some of which have also seen incredible volatility.
Will President Biden’s international plan to release 60 million barrels of oil make a difference?
I think this move is largely symbolic. Russia exports about 5 millions of barrels per day of crude oil, not to mention refined products. In other words, the 60 million barrels from the strategic petroleum reserves are enough to replace 12 days worth of Russian exports.
While very little of those exports make it to the U.S., their withdrawal from the global markets will have, and already has had, a substantial impact on the oil prices everywhere, including the U.S. While the administration has been encouraging U.S. oil companies to ramp up domestic production—in particular, in the fracking segment of the industry, where, in principle, it can be done relatively quickly—so far the response has been weak. This can be attributed to both intrinsic difficulties in the sector, which has undergone a couple of boom-and-bust cycles over the last decade, and to the secular shift towards renewable energy driven by the ESG [environmental, social, and governance] investment trend, which has left oil companies starved of capital that would be needed to rapidly increase investment.
COVID-19 has had a great influence on American spending habits. How is consumer behavior affecting the current bout with inflation?
The major driver of inflation on the demand, rather than supply, side has been the shift away from consuming ‘services’ during COVID to purchasing more durable goods (think Peloton bikes as a substitute to going to the gym). As demand for goods skyrocketed, supply chain constrains made it harder to satisfy, naturally leading to higher prices.
The hope is that as COVID recedes and people start traveling and going out more, as they have been already, services will come back and the demand for durables will abate. This should help ease inflationary pressures.
However, services are highly labor intensive, and we have seen the ‘great resignation’ phenomenon develop over the last year. Its causes are still debated, but the combination of childcare difficulties, fear of infection, risking stock wealth, and simply learning to enjoy personal/leisure time and a flexible work schedule may have all contributed. Together with the restrictions on immigration that have been in place since the Trump administration, this has led to widespread labor shortages. So, we could see a continued rise in labor costs, which would also fuel inflation.
Are supply-chain issues a factor in rising prices?
Absolutely. I would put the supply chain issues at the top of the list of causes of the current inflation bout, including both production disruptions due to COVID outbreaks and transportation bottlenecks, such port congestion, resulting from too many shipments occurring at the same time.
Where are things headed for Americans in the next six months?
The level of uncertainty has increased since the beginning of the year. We could see it from the recent FOMC [Federal Open Market Committee] decision to raise rates only by one quarter of a percentage point; many expected at least one half of a percentage-point hike. The war may have given the Fed some pause, although they will continue to tighten, if slowly, lest they lose all credibility.
One should remember that the Fed is often blamed for not moving aggressively to tame inflation in the 1970s, but it actually was much more aggressive compared to what we see today. Interestingly, one of the major reasons that the Fed did not raise rates aggressively in the mid-70s was the fear of a major recession as a result of the ‘oil shock’ that followed the 1973 Yom Kippur War. The resulting decade of ‘stagflation’ and ‘productivity slowdown’ is often blamed on this response, but in retrospect, that behavior looks much more hawkish than the Fed’s response that we observe today.
That said, it is not clear that a more aggressive tightening by the Fed now would succeed in bringing inflation down, while it would be almost sure to slow down the economy just as it emerges from COVID. I think the high inflation rates will stay with us throughout this year and probably next. It is hard to see rates below 4-5% in the near future. Whether they will be damaging to the economy is less clear.
Even the high oil prices, which are generally a drag on the economy, might not do as much damage as some fear, at least in the U.S. In part, this is because large parts of the U.S. economy might actually benefit from them. After all, the U.S. is right now the largest oil producer in the world thanks to the fracking boom of the past decade. In part, it is also because the U.S. economy is much less oil-intensive than it was in the 1970s.
Greater fuel efficiency, the rise of electric vehicles, as well as the now ubiquitous (and popular) telecommuting/working from home should soften the blow of oil prices to the economy. However, blue-collar workers, especially those in rural areas, will be hit the hardest by high gasoline prices, since they generally cannot switch to working from home and often have to drive long distances to work.
