By Howard Schneider

(Reuters] -The Federal Reserve’s attempt to stop loose money policy used in the fight to the coronavirus epidemic is being tested unexpectedly. The Russian invasion of Ukraine has created new risks for global financial markets.

On Wednesday and Thursday, Fed Chair Jerome Powell will testify in front of Congress. His first remarks on the economy for nearly five weeks, he’ll confront an environment that is markedly more complicated than January when he described a straightforward central bank initiative to reduce high U.S. Inflation.

The cure – rising interest rates, a possible reduction in Fed’s bond holdings and “nimble” observation to new data may be the best. The rate of inflation since Powell’s last speech has been increasing, and there is the possibility that the tension in Europe will add pressure. Tuesday saw the spot oil price jump to $103 per barrel. This represents a 17% gain since January’s U.S. central banks last policy meeting.

Powell may have to be cautious in his comments, as he assesses the world which has made the Fed’s job much more difficult in coming weeks.

With rising oil prices, U.S. Treasury Bond interest rates began to fall. This is a blow to what Fed considered a positive trend towards increasing market interest rates which would counter inflation.

The yield on the Treasury two-year note has been a key benchmark in Fed policy since the beginning of the conflict in Ukraine. It was as high as 1.622%, but it traded at 1.27% Tuesday.

Russia’s growing isolation has led to a higher risk-aversion and increased dollar financing costs in European credit markets.

Although the jump was not as large as the beginning of the pandemic when it became increasingly difficult to trade in normally open markets such that U.S. Treasury Bonds, the Fed intervened and bought massive bonds of its own to preserve the financial system.

It is important to remember that the sanctions against Russia will have a direct impact on global economic growth. This could lead to financial stress and slower overall economic growth.

The Fed raising interest rates at the Fed at times when energy costs rise can be associated with recessions. In a analysis, Michael Kantrowitz (chief investment strategist at Piper Sandler), wrote that the Fed cannot prevent a downturn and is “in the hands” of Powell and Russian President Vladimir Putin.

He noted that there is already a significant rise in energy consumption. If the Fed continues to hike rates at a faster pace, it could lead to recession by 2023.

The Fed may have a harder time justifying plans to reduce its bond holdings until international tensions are eased by tighter financing conditions at overseas companies and banks.

Ed Al-Hussainy (senior analyst, Columbia Threadneedle) stated that “so far all of this repricing has been orderedly.” However, the Fed may be “testing” its facilities that were set up in the aftermath of the coronavirus crisis in order to maintain financial markets’ smooth functioning, he stated.

Powell appears before Congress to state that he is 100% focused on addressing inflation. He said that two, market liquidity will be supported if needed… three, Treasury will work with us to impose sanctions against Russia and ensure the U.S. financial sector has sufficient capital and liquidity buffers in order to deal with spillover risk.”

FOCUS STILL ABOUT INFLATION

Powell will be testifying Wednesday morning at 10:00 EST (14500 GMT), before the U.S. House of Representatives Financial Services Committee. On Thursday, Powell will also appear before the Senate Banking Committee. This is Powell’s second congressional appearance. It coincides with the publication of a semiannual Fed Review of Monetary Policy.

The report was released last week, shortly after Russian forces invaded Ukraine, and included one terse mention that “recent geopolitical tensions related to the Russia–Ukraine situation are a source of uncertainty in global financial and commodity markets.The report’s main focus was U.S. Inflation, which is now at three times the Fed’s target of 2% and could rise further if more people fill the record-breaking number of jobs and supply chains deal with a backlog.

Powell will likely keep a lot of his attention on the Fed’s need to raise interest rates and prices.

The Fed’s current overnight benchmark interest rate is effectively zero. This does not reflect the U.S.’s relatively rapid recovery from its pandemic-induced depression of 2020. As the Fed stimulates an economy that is experiencing rapid growth, high wages and record worker demand, the gap between consumer inflation (and the Fed’s policy rate) is one of the largest on record.

Recent events could temper the Fed’s ability to catch up.

Fed officials had been sparring in recent weeks over whether to kick off the next round of interest rate increases with a larger than usual half-percentage-point increase at the central bank’s March 15-16 policy meeting, a debate that showed the different strategies favored by different Fed officials https://graphics.reuters.com/USA-ECONOMY/FED/lgpdwawwzvo/index.html.

The Fed’s interest rate was a key factor in the decision to raise the Fed policy rate. This belief stemmed from high inflation and previous comments by James Bullard (St. Louis Fed President) that the Fed would increase the rate.

The probability of such an increase is now estimated at around 5%.

We now understand what we’re dealing with, a prolonged standoff between Russia and Western Europe. In an analysis, BlackRock Investment Institute stated that it believes this has decreased the chance of central bank slamming on the brakes in order to control inflation. The interest rates are expected to rise. However, the central banks could face less pressure to control inflation because of rising prices and this conflict. It will be easier for them to act more carefully, we believe.