March 1 (Reuters) – The Federal Reserve’s plan to end loose monetary policies used to fight the coronavirus pandemic faces an unexpected early test as Russia’s invasion of Ukraine poses new economic risks and financial effects already felt in global markets.

Fed Chairman Jerome Powell is due to testify before Congress on Wednesday and Thursday, and his first comments on the economy in nearly five weeks will face a situation that has become significantly more complex since January, when he described a direct effort by the central bank to combat high US inflation.

The remedy – a steady rise in interest rates, a possible reduction in Fed bond holdings and an “agile” attention to new data – could remain largely intact. Inflation since Powell’s last speech has accelerated and the conflict in Europe could add even more pressure with the spot price of US oil surging above $103 a barrel on Tuesday – a 17% increase since the last policy meeting from the central bank at the end of January.

Join now for FREE unlimited access to Reuters.com

Register

But Fed policymakers, speaking on Tuesday, noted that the economic landscape had become much more uncertain in a short time.

“Our hard work just got a whole lot harder,” Atlanta Fed President Raphael Bostic said in an online seminar. “Energy is changing a lot. The ability for people and goods to move across Europe – looks like it’s going to change a lot. That has implications for supply chains and a whole host of things. There’s a lot of things that we need to understand.”

Central banks around the world face the same dilemma when assessing how much the war in Ukraine will hurt growth, raise prices, or both, and how that might affect local monetary policy read more.

The global role of the Fed and the status of the dollar as a safe haven make the situation even more delicate for American policymakers.

Along with rising oil prices, interest rates on US Treasuries began to fall – undermining what the Fed saw as a positive upward trend in market interest rates that would help counter the ‘inflation.

Since the start of the war in Ukraine, the yield on the two-year Treasury note, a benchmark for Fed policy, has risen to 1.62% but traded at 1.27% on Tuesday.

Russia’s growing isolation, with the freezing of its central bank assets and other sanctions beginning to weigh, has increased global risk aversion and raised the cost of dollar funding in European credit markets. Read more

The jump was smaller than at the start of the pandemic, when trading became difficult even in generally fluid markets like US Treasuries and the Fed stepped in with massive bond purchases.

Yet it reminds us that sanctions against the Russian government will have a potential cost in the form of slower global economic growth and increased financial strains.

Periods when rising energy prices sap consumer budgets at the same time as the Fed raises interest rates have preceded several recessions in the past, said Michael Kantrowitz, chief investment strategist at Piper Sandler, and it was now “in the hands of (Russian President Vladimir) Putin and Powell” whether it would happen this time.

“We already have a big increase in energy spending,” he noted, and if the Fed continues a more aggressive pace of rate hikes, “we’re likely headed for a recession in 2023.”

Reuters Charts

Tighter funding conditions for foreign banks and companies could also make it harder for the Fed to justify its plans to cut its own bond holdings until global tensions ease.

“So far, all the repricing in the dollar risk and funding markets has been ordered,” said Ed Al-Hussainy, principal analyst at Columbia Threadneedle. But the new uncertainty could test the effectiveness of the facilities the Fed put in place during the coronavirus crisis to keep financial markets functioning, he said.

“I think Powell sits down in front of Congress this week and says…we are 100% focused on reacting to inflation…We will support market liquidity if needed…We will work hand in hand. hand with the Treasury to impose sanctions on Russia and ensure that the American financial system has the reserves of capital and liquidity to manage the risks of contagion, ”he said.

FOCUS STILL ON INFLATION

Powell will testify at 10 a.m. EST (1500 GMT) on Wednesday before the U.S. House of Representatives Financial Services Committee and concurrently on Thursday before the Senate Banking Committee, one of two congressional appearances the leader of the Fed coinciding with the publication of a semi-annual report by the Fed. monetary policy review.

The report was released last week, shortly after Russian forces invaded Ukraine, and included a terse mention that “recent geopolitical tensions related to the Russian-Ukrainian situation are a source of uncertainty in global financial and commodity markets”. read more The report focuses on US inflation, which is now at triple the Fed’s 2% target and, according to the document, is likely to remain higher than desired unless more people start to fill the record number of open jobs and that supply chains are operating through a pandemic backlog.

Powell is likely to retain much of his attention during the hearings on inflation and the need for the Fed to start raising interest rates.

Reuters Charts

The current setting of the Fed’s benchmark overnight interest rate, effectively at zero, is out of sync with the U.S. economy’s relatively rapid exit from the pandemic-induced recession of 2020. The Gap between consumer inflation and the Fed’s key interest rate is the widest on record as the central bank fuels an economy enjoying rapid growth, rising wages, strong consumer spending and record demand for workers.

But recent events could temper how quickly the Fed is trying to catch up.

Fed officials had been squabbling in recent weeks over whether to kick off the next round of interest rate hikes with a bigger-than-usual increase of half a percentage point at the meeting. central bank policy from March 15-16, a debate that showed the different strategies favored by different Fed officials.

Traders in markets tied to the Fed’s key interest rate, buoyed by high inflation and earlier comments by St. Louis Fed Chairman James Bullard, were convinced as early as February 10 that a bigger hike rates was ongoing.

Reuters Charts

They now estimate the probability of such an increase at around 5%.

“We now know what we’re dealing with: a protracted standoff between Russia and the West. We also believe this has reduced the risk of central banks stepping on the brakes to contain inflation,” said BlackRock Investment. Institute in an analysis. Interest rates” are rising. Yet central banks may face less political pressure to contain inflation as conflict becomes an easy culprit for rising prices. We believe this will allow them to act with more caution.”

Join now for FREE unlimited access to Reuters.com

Register

Reporting by Howard Schneider; Editing by Dan Burns, Paul Simao and Andrea Ricci

Our standards: The Thomson Reuters Trust Principles.