• Fed signals end of interest rate hikes and expects “mild recession”
• Recession does not necessarily lead to a fall in inflation
Even though the stock markets have trended upwards in recent weeks, the issues of inflation and recession are more relevant than ever. US inflation data for March showed that year-on-year inflation fell from 6.0 percent to 5.0 percent. The decline was even stronger than expected. However, the situation is different if you look at the core inflation rate (excluding energy and food). This increased from 5.5 to 5.6 percent. However, this slight increase was expected. It is the first time in two years that core inflation has moved above headline inflation. According to VP Bank economist Thomas Gitzel, 50 percent of inflation is now due to rents, as the German Press Agency writes.
But even if inflation is still at a high level, the US Federal Reserve indicated in its most recent meeting minutes that the rate hike cycle is nearing its end. Most recently, in March, the Federal Reserve raised interest rates again by 25 basis points to a range of 4.75 to 5.00 percent – despite the banking crisis – to underline its determination to fight inflation. Now investors are speculating whether there will be another low in May rate hike come or an interest rate pause is inserted, the declared 2 percent target of the central bankers has not yet been reached.
Numerous economists are now convinced that tighter monetary policy triggered recession can no longer be stopped. So could such an economic downturn wipe out the last bit of inflation?
That’s why a recession could lead to less inflation
In theory, this approach is quite understandable. The tighter monetary policy withdraws money from the market as fewer loans are made and these also become more expensive. So there is less investment, people are buying less or postponing large purchases such as a house to a later date, companies are going bankrupt and unemployment is also rising. All of this should help keep inflation down. In the minutes of its most recent meeting, the Fed itself was convinced that there would be a “mild recession” in the further course of the year.
Nonetheless, Bloomberg columnist Allison Schrager argues in a piece that the market should not count on the recession triggered by tighter monetary policy also pushing inflation to target levels. In reality, the connections between the economy and inflation are not so straightforward. Instead, various scenarios are conceivable.
risk of stagflation
According to the financial expert, it is possible that a recession will occur, but inflation will not go down as desired, but will remain high – as happened in the 1970s, when so-called stagflation occurred. Such a scenario could occur if there is another supply shock, such as a surge in energy prices. In such a case, the Fed would have to lower interest rates again to cushion the economic impact, but this would fuel inflation again. The worst-case scenario could be a recession while inflation remains high.
Inflation is not reduced sufficiently
In the Bloomberg columnist’s second scenario, inflation will be depressed by the recession, but not enough to meet the Fed’s 2% target. According to the expert, it is difficult to predict how far economic output would have to fall in order to push inflation down to the desired target. The economist Jason Furman recently calculated that inflation would have fallen between zero and 1.9 percent during the last recessions, but that would still not be enough given the current inflation rate of five percent. The Fed itself assumes that the unemployment rate will have to rise to 4.6 percent in order to bring inflation down sufficiently. However, financial professional and former US Treasury Secretary Larry Summers predicted last fall that unemployment was more likely to rise to six percent.
Fed credibility problem
As a third argument, Schrager puts forward that the US central bank is now also struggling with a credibility problem. Even though the Fed has always announced that it will stick to the 2 percent target, the market is now speculating that the first rate cuts could be imminent. However, Federal Reserve decisions carry more weight when people also believe that the Fed’s goals will be enforced rigorously. After all, consumers and companies behave differently if they expect inflation to fall soon. Then perhaps prices will not be increased after all, or large salary increases will not be demanded. The situation is different, however, if people have to assume that the price level will remain high, which then creates the danger of a wage-price spiral. In such a scenario, however, the central bank can find itself in a quandary where the economy slides into recession due to higher interest rates, but inflation still fails to come down due to people’s expectations. Here, the Fed can only hike further to reinforce its determination to lower inflation – but it also creates more stress for consumers and the economy. Or they accept the high inflation and say goodbye to their 2 percent target.
In any case, the Bloomberg expert summarizes: “Even a recession may not be able to stop inflation”.
Editorial office finanzen.net
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