Why a Fed-Driven Recession Is Preferable to Stagflation

About the author: Dana M. Peterson is the chief economist at The Conference Board.

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Six months later, Russia’s war is still taking a terrible toll on millions of Ukrainians, but also on billions more people around the world through rapidly rising inflation, shortages, financial market volatility, and risks of recession.

Although some commodity prices have eased from their year-to-date peaks, they remain elevated, stoking the cost of intermediate and final goods that utilize these products. Higher input costs for firms are being passed onto consumers, causing both price spikes for household basics and aggressive interest rate hikes by central banks. Higher interest rates not only reduce domestic demand but also place overly-indebted economies at risk of default.

The US Federal Reserve raised interest rates by three-quarters of a point on Wednesday, following an increase of the same size in June. The Fed’s interest-rate hike campaign is strengthening the US dollar, leading to weaker foreign currencies—and to devastating inflation for the world’s other economies. Higher inflation, central bank tightening, and foreign currency depreciation are raising the Specter of recession for many economies, including here in the US Certainly, if the US goes into recession, and China and the euro zone slow considerably, then another global economic downturn could be on the horizon.

For the US, the shock of a regional war in Eastern Europe is now morphing into a recession at home. The root cause is the increased global inflation linked to the war and an aggressive Federal Reserve response to that inflation, which also includes shrinking the size of its balance sheet. What is spurring higher prices and how will the Fed’s actions result in recession?

To date, supply and demand drivers have fueled US inflation. The former includes continued supply-chain bottlenecks associated with China’s zero-Covid policy, and rising wages due to labor shortages and the “Great Resignation.” Demand drivers included powerful household demand for goods during the worst of the pandemic, and strong desire for services now with it in the rearview mirror. Additionally, low interest rates fueled demand for homes and financed goods like automobiles, and consequently increased their prices.

The war in Eastern Europe only added to the supply-side inflation shocks. Ukraine and Russia are major global suppliers of grains, energy, assorted rare metals and gases (platinum and neon, for example), cooking oils, and fertilizers. The inability to produce and export these products due to destruction, sanctions, or blockades associated with the war raised these goods’ global prices. Additionally, shortages of these materials raise costs for transportation and semiconductor production, the latter of which are found in most everything businesses and consumers use.

But the Fed’s mission, according to Federal Open Market Committee officials, is to tamp down inflation in its entirety, not just certain elements. The FOMC has penciled in an increase in the federal funds rate to 3¾-4% sometime next year in the Summary of Economic Projections. While that is by no means a forecast, it does indicate a hawkish stance from a central bank aiming to achieve several objectives: lower inflation back to the 2% target; keep long-term inflation expectations anchored; prevent a wage-price spiral; and maintain the Fed’s credibility.

Interest rates heading into what would be considered restrictive territory—the federal funds rate exceeding 3%—would mean significant tightening in monetary policy on a meeting-by-meeting basis. The Fed’s trajectory portends material slowing in domestic demand. Higher interest rates will make it more expensive for businesses to invest in capital, structures, and intellectual property; and increase households’ costs for financing big-ticket items (such as cars, furniture, homes, cell phones), reducing consumer spending. These sudden curbs on domestic demand will likely lead to a US recession before the year’s end.

A US recession would not go unnoticed around the world, particularly among major US trading partners such as Canada, Mexico, the Eurozone, and China. Reduced trade could also slow those economies. Meanwhile, many US trading partners’ central banks, with the exception of China, are tightening their monetary policies in response to higher domestic inflation and imported inflation from US dollar appreciation. Significant slowdowns or recessions in the US, Europe, and China could trigger another global recession.

Even without recessions, many economies, especially the US, are experiencing stagflationary environments. Stagflation is essentially a period of low growth and elevated inflation. An extended period of stagflation is potentially more harmful than a brief recession.

That is why the Fed is intent on wrestling inflation to the ground. Its policy makers want to ensure that expectations of higher inflation do not get embedded in the psyche of consumers, firms, and financial markets in order to avoid a period of lengthy stagflation. It is also trying to end higher prices’ corrosive effects on household balance sheets, particularly those of low- and moderate-income Americans. While this might create a period of pain, in the form of what we believe will be a shallow and brief recession characterized by negative GDP growth rates and some job losses, the alternative—rampant inflation—is more unsatisfactory.

The good news is that interest rate hikes are occurring against a backdrop of underlying strength in the US economy. This is most evident in the labor market, which by many measures is well beyond the 4.4% unemployment rate the Fed might classify as full employment.

The tight labor market heading into the Fed’s tightening cycle may even help to limit the number of jobs lost during the likely recession. Labor shortages continue to be a major problem and job openings abound. Indeed, many firms may reduce hours, halt 401(k) plan contributions or deploy other measures short of layoffs to keep the workers they fought so hard to attract and retain.

So, while the peaking of commodity prices may have taken place, the US and much of the rest of the world is still likely to experience continued pain ahead. This time it’s coming in the form of recessionary environments, characterized by weaker growth and renewed labor market strains.

Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to [email protected]

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