By Howard Schneider

WASHINGTON, (Reuters) – The U.S. Federal Reserve’s fight against inflation is already difficult by the unpredictability of a once in a century pandemic. Now, there will be an energy price shock as well as additional uncertainty after Russia’s invasion of Ukraine.

Oil prices shot up overnight. Futures for oil reached $100 per barrel, the highest level since 2014. Stock prices dropped by approximately 2% in U.S. early trading.

(Graphic: U.S. oil prices surge after Russia invades Ukraine – https://graphics.reuters.com/UKRAINE-CRISIS/USA-FED/gdvzybqwypw/chart_eikon.jpg)

Investors all but ruled out a larger half-percentage-point rate increase at the Fed’s March meeting, with CME Group’s (NASDAQ:) widely followed FedWatch tool signaling at one point the probability of that large a hike had been cut by two-thirds overnight to less than 10%. The Fed is likely to increase its target policy rate by a quarter point from the zero-level it set in the beginning of the pandemic.

Thomas Barkin, President of Richmond Federal Reserve said that the U.S. should raise interest rates because there is “underlying demand”. The labor market remains tight. High inflation is increasing and the trend towards higher prices continues.

Despite the events in Ukraine, “I don’t think you are going to see much change to the underlying logic…But this is uncharted territory so we will have to see where the world goes.”

Even before the attacks, Fed officials began to consider the consequences. Raphael Bostic, Atlanta Fed President, stated that his team had already begun to analyze the possible impact and any negative effects on business investment should global conditions get worse.

Minutes before the invasion of San Francisco was announced, Mary Daly from San Francisco Fed stated that U.S. inflation is high, and the labor market is strong. She said the Fed should keep raising rates, even with uncertainty about a conflict between Ukraine and Russia. She said Wednesday at an event in Los Angeles that she doesn’t think “unless circumstances get worse” that this would have any effect on the Fed’s March rate hikes.

However, officials will now be more cautious until it becomes clearer what the extent of Russia’s actions are and how they impact oil prices, financial markets, the economy and other areas.

Jennifer McKeown, head of Capital Economics’ Global Economics Service, stated that she believes we are at a tipping level where it could begin to impact confidence. She also knows that financial markets will be affected by this situation.

Although it is unlikely that tightening will be halted, “central banks may now be more inclined to be beginning to worry about adverse economic consequences and being cautious.”

The United States’ and European responses to Russia’s actions are also important. This could add to the fact that central banks may be dealing with the worst of both the worlds, which is higher inflation and slower growth. With the European Central Bank’s policymakers meeting Thursday in an informal gathering, that could become a crisis meeting, it appears as though the European economy risk is more severe than for the United States.

However, this crisis may delay the resolution to prominent factors which have caused U.S. inflation higher, like global supply bottlenecks. These could cause price pressures to rise while reducing growth prospects.

(Graphic: Fed policy rate and inflation hit a record gap – https://graphics.reuters.com/USA-ECONOMY/FEDFUNDS/movandmydpa/chart.png)

The analysts at ISI Evercore wrote that the impact of the stagflationary surprise could have a net hawkish effect beyond the immediate term. Both the negative sides of the macro distribution are moving up: The right tail risk for continued excessive inflation in the medium-term and the left tail threat that attempts to reduce this inflation…end up leading to a recession.

Analysts from TD Securities said that this would “complicate central bank policy responses in the face of large disruptions to energy prices and supply chains.” Although the Fed and U.S. could be sufficiently removed to maintain their planned hikes, risks shift towards 25 basis point increments instead of anything more drastic.