Goldman sachs: Nothing to stop the Fed from raising rates by 25bp in March

The Fed faces a more complicated situation than ever, with geopolitical risks driving the prices of several commodities to record highs and inflation rising sharply.

On the other hand, surging commodity prices hamper the global recovery and could lead to a faster and more painful downturn. What exactly will the Fed do?

In Goldman's view, however murky the risk events, the Fed's stated direction will remain intact.

According to Goldman Sachs, the current level of event risk is only the fourth highest in the last 40 years.

It stands to reason that geopolitical risk must factor into the minds of central banks, especially the Federal Reserve, as they assess whether to continue monetary tightening.

To be sure, central banks are always cautious about tightening financial conditions, or at least easing them moderately, in major global geopolitical conflicts, especially if a global recession is one of the potential side effects of a full-blown Russia-Ukraine conflict.

On Thursday, Goldman Sachs Chief economist Jan Hatzius analyzed the potential impact of a potential Conflict between Russia and Ukraine on the U.S. economy and Federal Reserve policy.

Jan Hatzius argued that any direct impact of the conflict on the U.S. economy would be limited because trade links with Russia and Ukraine are weak and energy prices are likely to be affected much less than in Europe.

The surge in oil prices, however, is a big red flag. According to Goldman sachs, a $10 per barrel increase in oil prices would add 3.5 per cent to core inflation and 20bp to headline inflation, but would knock less than 0.1 per cent off GDP growth.

While geopolitical events are certainly negative for inflation and growth, the impact of tighter financial conditions is the least predictable. Data suggest that past geopolitical risk events have rarely been followed by a material tightening of US financial conditions, although it is hard to generalise to the present.

As Goldman Sachs says, "Further tightening of financial conditions and increased uncertainty for businesses will be a further drag on US growth".

So what does this mean for the Fed?

Goldman acknowledged for the first time that Wall Street's consensus estimate of as many as seven or more Fed rate hikes in 2022 May not materialise because "the monetary policy implications of the combination of upside risks to inflation and downside risks to growth are complex".

Historically, Fed officials have sometimes tended to delay major policy decisions until the uncertainty surrounding geopolitical risks abates.

For example, the FOMC also lowered the federal funds rate on September 11, 2001, or during 2018. Of course, that's not an option right now, with interest rates at 0% and inflation already at 7.5%.

Looking back at the Fed's historical approach to geopolitical events, Goldman sachs focuses on the Fed's current situation.

"The current situation is different from past occasions when geopolitical events caused the Fed to delay tightening or easing, as inflation risks create a stronger and more pressing case for tightening today than in past occasions," the bank said.

Jan Hatzius noted that with some wage price dynamics showing signs that near-term inflation expectations were already high, "further increases in commodity prices may be more of a concern than usual".

Thus, while Goldman does not expect geopolitical risks to prevent the FOMC from steadily raising rates by 25bp at its upcoming meeting, "we do think geopolitical uncertainty further reduces the likelihood of a 50bp hike in March".

In short, Goldman sachs doesn't think the fed will be deterred from raising rates by 25bp in March because of the russia-ukraine incident. At least four Fed officials have said publicly in recent days that uncertainty over geopolitical events is an important factor in the us economic downturn.

Goldman sachs believes some Fed board members see the negative impact of geopolitical events on the US economy as a compelling reason not to raise rates by 50bp in March.

For now, the markets seem to agree with Goldman. After reaching nearly 100 per cent probability of a 50bp hike in March earlier this month, the odds have now fallen to 20 per cent.