Goldman: Soaring commodity prices add more confusion to where the Fed goes from here

Published Mon, Mar 7 20222:30 PM ESTUpdated Mon, Mar 7 20223:05 PM EST

Surging commodity prices and the corresponding impact they have on both inflation and broader economic growth have put the Federal Reserve into an even tighter box in terms of policy. Markets generally expect the Fed to begin a tightening path shortly to stem escalating inflation. Those price pressures have intensified during the war on Ukraine , as energy, metals and agricultural commodities all have hit multiyear highs. While the trend now is not seen as an immediate danger to growth, the longer the war continues, the greater chance it could have more significant impact on both the U.S. and global economies. In turn, that has caused some confusion about what it will mean for Fed policy. A Goldman Sachs note to clients Sunday reflected the difficult choices central bank policymakers face. The bank's economists said they are sticking with their call that the Fed will hike benchmark interest rates seven times this year, but there are risks to that forecast in both directions. "The risks around our baseline funds rate path have grown. There is some risk that the fresh price shock will unanchor inflation expectations and force the FOMC to tighten in larger 50 [basis point] increments down the road," Goldman chief economist Jan Hatzius wrote. A basis point is 0.01%. "But there is an even bigger risk that the adverse shock to the global economy will trigger a large tightening in financial conditions that persuades Fed officials to pause (or even reverse) the hikes before too long," he added. "Thus, we now view the risks to our baseline funds rate forecast as more clearly tilted to the downside than before the invasion." Markets currently are pricing in up to six 25-basis-point rate hikes this year, which Hatzius thinks is about right despite Goldman's more aggressive call. However, current indicators are that after the Fed gets its benchmark rate up to about 2% — the equivalent of eight increases from the current 0%-0.25% target rate — that will be the end, the result of moves expected to conclude by the end of 2024. That "rate path beyond 2022 is too low," Hatzius said. "Although the risk of an early reversal by the FOMC has clearly risen, so has the risk of a more lasting inflation increase that lifts the nominal funds rate back to the 4-5% average of the 1990s and early 2000s on a sustained basis," he added. "After several decades in which economic, financial, or political shocks invariably caused interest rates to fall, markets may have to relearn that the opposite can also be true." Risk rising of a 'severe recession' Stocks have been volatile through 2022 so far, with early-year declines spurred by Fed uncertainty and the most recent leg lower caused mostly by the war. The policy response to both will loom large. Should commodity price increases keep zooming higher, that could lead to substantial economic problems, according to Joe LaVorgna, chief economist for the Americans at Natixis. "Higher food prices will hurt consumer spending because, like energy, there will be less discretionary money available to spend," wrote LaVorgna, the chief economist for the National Economic Council under former President Donald Trump. "Over time, households can change behavior and conserve on food and energy. In the short run, however, the economy will experience commodity-led demand destruction." Prices across the commodity spectrum soared Monday, continuing a pattern since the hostilities in Ukraine escalated. Spot prices for palladium, a critical metal in the production of electronics products, briefly broke through $3,000 an ounce and are up 36% since Feb. 11. Wheat futures jumped 7% on Monday and have exploded 68% over the same period. And, of course, oil prices continued to course higher, rising more than 5% for U.S. benchmark West Texas Intermediate, which has soared 35% in that 3½-week span. LaVorgna said an inflation-fighting Fed can cause damage at a time when consumers are dealing with such pernicious inflation. "The current stagflationary backdrop raises the risk of a Fed error if it leads policymakers down a more aggressive rate hiking path," he said. "If so, this would weigh sharply on stocks. The resulting negative wealth effects would then weaken demand beyond the effects of higher commodities. A severe recession could ensue." The Fed begins its two-day meeting a week from Tuesday. The central bank will have to be deft at laying out not just the immediate rate hike expected but also in charting a course forward. A Fed bent on tightening regardless of current conditions could be enough to send financial markets for another jolt. "I don't think it causes the Fed to be reticent about starting the normalization of rates process next week," said Deborah Cunningham, chief investment officer for global liquidity markets at Federated Hermes. "The Fed has multiple tools. They've used them on the way down in interest rate changes, and I think they can use them equally in this path going upward. It's just now a little bit more focused with the advent of this global conflict."

Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a House Financial Services Committee hearing in Washington, D.C., U.S., on Wednesday, March 2, 2022.

Julia Nikhinson | Bloomberg | Getty Images

Surging commodity prices and the corresponding impact they have on both inflation and broader economic growth have put the Federal Reserve into an even tighter box in terms of policy.