INFLATION VS. RECESSION
The Fed‘s Dilemma: Inflation vs. Recession
Soft landing is highly unlikely. Here is why.
The Fed’s Mistake
After last Friday’s 8.6% yoy CPI report removed all hopes that inflation had already peaked, it became clear that the Fed had been way behind the curve in combatting inflation.
It even came to a point where a 75bp rate hike at a single meeting would make the markets feel better than a 50bp hike, because the latter would likely leave the markets uneasy with respect to the Fed’s ability to take on inflation.
Especially after Russia’s war on Ukraine, food and energy prices all over the world are going up in alarming rates.
With the expected inflation climbing along with inflation now, the Fed is expected to turn extremely hawkish in this week(today)’s FOMC meeting with a “giant” step of 75bp rate hike.
While it’s easy to blame the Fed for being too late in beginning rate hikes and being completely wrong in its forecasts, we must admit the Fed is facing a very difficult market situation that it has never before experienced.
The Oxymoron: Inflation & Recession
Here is the dilemma arising from the current market situation:
- Extremely high inflation → Needed Solution: rate hikes & monetary tightening to slow down spending
- Recession risk → Needed Solution: rate reductions & monetary easing to encourage spending
See the direct contradiction in the solutions needed to solve the two problems?
Given the supply side doesn’t improve, reducing demand is the only way to bring down inflation. Thus, rates are raised with the aim of slowing down consumption.
However, slowing consumption will lead to a recession, which needs the exact opposite solution of lowering rates to re-encourage consumption.
Notice the problem? Encouraging consumption prematurely when inflation isn’t completely controlled risks bringing inflation expectations back up.
The Current Situation
Right now, the Fed has begun its rate hikes and monetary tightening to combat high inflation.
Recession has not come, yet, but with rates rising so much so quickly and all sorts of market interest rates rising to levels not seen in more than a decade, fears of recession are spreading, as overall consumption is expected to soon decline substantially.
While deteriorating consumer outlook and reduced consumption will likely (and hopefully) start to bring down the high inflation rate, it will on the other hand, very likely bring with it a substantial recession.
So, when such a big recession occurs, the Fed must shift back its policy to encourage spending so that the economy can recover.
This is where the real difficulty comes.
Why It’s So Hard This Time
Following the pandemic shock, the huge risk of recession made the Fed reduce rates to zero and pour unprecedented amount of money into markets, helping the economy recover from the pandemic shock and causing the current inflation in the midst of global supply congestions. When the Fed did this in early 2020, there was no hindrance to implementing such easy monetary policy because the economy was facing more of a deflationary pressure rather than inflationary.
However, the risk of recession right now, as of 2022, comes directly from the high inflation rate, especially in the necessities like food & energy, which is making the Fed raise interest rates and tighten money supply. Such a sudden tightening of monetary conditions is expected to tank the overall consumption in the economy, creating a big recession.
With the inflation rate currently at 8.6% and the Fed’s target at 2%, even though the inflation rate starts going down with declining consumption and potentially a recession, the Fed can’t shift to easy policy unless there is “clear and convincing evidence” that inflation has stabilized.
Let’s assume the inflation rate goes down to 4% by the end of the year with continued rate hikes that brings the Fed rate to over 3%.
By that time, I believe it is highly likely that overall consumption would have tanked and the global economy in a dismal state. Support from the government and the Fed would be crucial for the economy to recover from such a severe recession.
But can the Fed provide such needed support by shifting back to easy policy and lowering rates and resuming bond purchases to combat the recession?
It would be a very difficult and delicate issue, simply because shifting back to easy policy before inflation has completely stabilized can bring back the expectations of inflation. If done wrong, the economy would fall into a dismal cycle of rising inflation expectations and continuing recession, just like the 70s.
Allowing and watching the economy suffer from severe recession without being able to help would be such a difficult thing for the Fed to do and for the markets to endure. But as Volcker had done and Powell is aware of, completely controlling inflation must come first, even if a huge recession comes.
Only after the inflation is “clearly and convincingly” controlled and stabilized, then will the Fed be able to shift back to easy-money policy for good, and only then will the stocks likely enter back into a long-term expansion phase.
