Douglas Porter

March 4, 2022

The run-up in oil prices is the single most important economic development for North America from the Ukraine conflict, at least so far. Amid the gyrations in financial markets, the deep dive in the Russian ruble, and the tough sanctions, it can be a challenge to sort through the biggest drivers for the outlook. But it’s oil that has made a very big move and has very wide-ranging implications. As the dust is settling, WTI has stepped up by more than US$20/bbl from a week ago to above $110. This move heightens an already intense inflation backdrop while also introducing some serious downside risks for growth, complicating what was initially a complex economic environment.

When markets closed the books on last week, most prices had seen remarkably little net moves after the invasion began, aside from a notable drop in the ruble. That all changed this week, as both markets and Russia (apparently) were surprised by the severity of sanctions, including a partial ban from SWIFT and a freeze on Russia’s central bank reserves. Unable to properly defend the currency, the ruble promptly fell by nearly 25% despite a spike in short-term interest rates to 20%. Amid the chaos this and other sanctions could cause in Russia, we now expect that economy to contract by up to 10% this year. While energy sales have not yet been directly sanctioned by most, there appears to be almost a de facto move in that direction, especially as Western companies are now self-sanctioning in a broad fashion.

Commodity prices are forging higher almost across the board, given Russia’s heavy weight in so many different resource products. To pick but one example, the Bank of Canada’s commodity price index jumped 4.4% in the past week alone, and is now up 45% y/y (with the ex-energy component at an all-time high). Wheat prices have spiked almost 50% in the past month from already-robust levels, following a poor North American crop last year and amid concerns about Ukraine’s crop this year. In an unrelated move, lumber prices are also quietly taking a run at the extreme peaks of last spring, rocketing more than 40% in a month. Compounding the spike in commodity prices, the conflict threatens to further snarl a variety of global supply chains, further delaying a recovery in sectors such as autos.

While the broad move in resource prices is notable, the jump in crude is the most visible and most important shift. We estimate that, if sustained, this latest run-up will add about 0.8 percentage points to headline inflation in North America. The U.S. CPI for February is the showpiece economic release for this coming week (due Thursday), and it is expected to be a whopper. We are looking for a hefty 0.9% monthly move, which could lift the headline annual rate to a towering 8% pace. Incredibly, it could go higher yet in March, due to this latest run in gasoline prices. And it’s not just energy prices, as core CPI is driving above 6%. It’s also not just a U.S. issue, as the Euro Area’s early read on February inflation smashed expectations this week with a 0.9% m/m rise and a yearly rate of 5.8%. Europe’s inflation outlook faces the additional upside risk from spiking natural gas prices; a run to double-digit headline inflation is conceivable, at least for a temporary spell.

How should central banks respond to this challenging economic landscape? Both the Federal Reserve and Bank of Canada weighed in directly this week, and the message was similar. Chair Powell bluntly stated that high inflation is the primary issue, but the Fed will proceed cautiously given the downside growth risks. In a rare show of his hand, Powell told the world he would be voting for a 25 bp rate hike in the coming FOMC meeting. The Bank, meantime, stared down the conflict and went ahead with its first 25 bp rate hike on Wednesday, although decided to hold its balance sheet steady (surprising some). In a speech the next day, Governor Macklem warned about broadening inflation pressures, the risks of expectations becoming unmoored, and the possibility of 50 bp steps later this year.

Still, the overall net market reaction to this relatively firm commitment to rate hikes from both banks was to take yields lower across the curve this week. After nudging up a touch last week, the 10-year Treasury yield retreated a heavy 24 bps to 1.73% by mid-Friday. Two-year yields also faded 9 bps, but this still flattened the 10s/2s curve to 25 bps—a narrow spread, particularly given the fact that we have not even had step 1 in the Fed’s tightening cycle yet. Canada’s curve moved almost in lockstep with Treasuries, with an unusual 14 bp drop in two-year GOC yields in a week when three-month bill yields rose almost 30 bps on the BoC’s moves.

In some ways, the bond market is perfectly capturing the new stresses for the economy—higher inflation, lower growth. The drop in North American nominal yields is entirely due to a sharp pullback in real yields—reflecting a darkened growth outlook, and some flight-to-safety—even as inflation expectations and breakeven rates have (understandably) pushed higher. The only quibble would be with the relative mix, as it seems like the change in the inflation outlook is much more intense than the downside for growth, at least at this stage. From just prior to the invasion, 10-year real Treasury yields have dropped almost 50 bps, while inflation breakeven rates have risen a bit more than 20 bps (leaving nominal yields down almost 30 bps).

Given the abrupt moves, as well as a wide range of potential additional risks—the threat to the Ukrainian nuclear plant, for example—the relative stability of equities is notable. Even with late-week weakness, the S&P 500 and the TSX stood a bit above pre-invasion levels by Friday noon. Providing a modicum of support is the fact that North American growth came into the storm with better-than-expected momentum. In the U.S., the February jobs report was sturdy, with payrolls (+678k), hours worked (+0.8%), and the jobless rate (3.8%) all stronger than expected. In Canada, GDP managed to nudge up 0.2% in January despite a big pullback in jobs, and we look for a partial rebound in the latter in Friday’s employment release. As a result, the growth outlook for the full year has not yet buckled in North America, as small upside revisions to the start of 2022 may partly offset near-term downside risks.

After all but mocking stagflation chatter a few months ago, we must now humbly admit that the recent traumatic events in Eastern Europe have indeed introduced those very risks to the outlook. The oil shock, combined with the broad run in most other commodities and supply chain snarls, are an unwelcome reminder of the early 1970s. OPEC’s oil embargo of 1973/74 prompted a quadrupling in crude prices (from $3/bbl to $12), and caused U.S. CPI inflation to surge from an (already high) 7.4% y/y pace in September 1973 to above 10% within six months. (In an eerie echo, the current U.S. inflation rate is almost identical to that starting point.) While the deterioration in growth and employment took a bit longer to respond, the U.S. jobless rate jumped from 4.8% to a 9.0% peak in under two years.

Comparing and contrasting the global economy to that episode and today’s situation is worthy of a much deeper dive. But one key point is that oil prices never looked back after the huge step up in late 1973. Likewise, the fate of global growth and inflation in 2022 depends heavily on whether this big move is sustained.

Doug Porter is chief economist and managing director, BMO Financial Group. His weekly Talking Points memo is published by Policy Online with permission from BMO.