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Is Recession The Only Cure For Inflation?

By James PicernoMarket OverviewFeb 10, 2022 02:37PM ET
www.investing.com/analysis/is-recession-the-only-cure-for-inflation-200617705
Is Recession The Only Cure For Inflation?
By James Picerno   |  Feb 10, 2022 02:37PM ET
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As the Federal Reserve prepares to start raising interest rates, history lurks in the background amid an inflation surge that’s remained more persistent than expected.

The standard treatment for a run of inflation that’s become too hot to tolerate is to adjust monetary policy to fight the beast. Invariably that shift translates to higher interest rates, which often leads to recession. Not immediately, but the apparent causal link between a rise in the Fed funds target rate is hard to ignore.

In the chart below, a runup in core PCE inflation tends to break either during or soon after economic recessions. It’s not clockwork, but neither is this a random relationship. So the question of how to assess future risk arises anew as the start of a new policy regime is set to begin when the Fed rolls out a new policy announcement on March 16.

Federal Funds Rate/Core PCE Historical Chart.
Federal Funds Rate/Core PCE Historical Chart.

Lest anyone doubt the accumulating hints that the central bank has been dropping, a fresh wink wink nod nod was offered yesterday, when Cleveland Federal Reserve President Loretta Mester advised:

“Each [FOMC policy] meeting is going to be in play. We’re going to assess conditions, we’re going to assess how the economy’s evolving, we’re going to be looking at the risks, and we’re going to be removing accommodation.”

Atlanta Fed President Raphael Bostic offered a similar analysis this week, explaining that

“In terms of hikes for the interest rates, right now I have three forecast for this year. I’m leaning a little towards four, but we’re going to have to see how the economy responds as we take our first steps through the first part of this year.”

There’s no law iron-clad law that dictates that a central bank that pivots to fight inflation (as opposed to the long-running effort to raise inflation that’s now ended) is destined to trigger recession. But history suggests the odds aren’t exactly low for predicting otherwise. Lisa Shalett, chief investment officer of Morgan Stanley) Wealth Management, in December observed:

“The Fed knows what to do, but they don’t necessarily know how to do it without squashing the economy.”

Will it be different this time? Possibly. Using history as a guide to the future for real-time economic analysis is fraught with many caveats. But as a starting point for discussion it’s useful to ask if the current runup in inflation will lead to a policy mistake that triggers a recession? Stranger things have happened.

Are higher interest rates enough to tip the economy into recession? No, at least not yet. There’s enough forward momentum to keep the expansion humming. But that appears to be true ahead of most if not all downturns and so we should be humble about assuming that we can see around corners or that today’s analysis will stay fresh through next week.

That leaves the standard approach: monitoring the economy in real time and applying informed nowcasting analytics to routinely evaluate (and re-evaluate) recession risk across a broad, diversified set of numbers. It’s still impossible to accurately forecast the timing of future recessions, much less their severity or duration. That leaves the only game in town: carefully estimating the odds that a new recession has started, and reassessing each day.

Those odds are currently low, based on a broad set of indicators and various econometric techniques. But here’s one forecast you can count on: the analysis will continue to fluctuate.

Meanwhile, it appears that the central is in a bit of a pickle. As Desmond Lachman, a senior fellow at the American Enterprise Institute, observes:

“The Fed has got itself into the most unenviable of monetary-policy dilemmas.”

If it fails to raise interest rates aggressively now, it risks allowing both inflation expectations to become entrenched and further froth to be added to already bubbly asset and credit markets. That in turn would set the US up for an even harder economic landing down the road than if it now acted in a timely manner. On the other hand, if it were to raise interest rates aggressively now it might succeed in getting the inflation genie back into the bottle, but at the price of bursting today’s everything asset-price and credit-market bubble.

Choices, choices amid so much imperfect real-time information. Alas, no one knows what the optimal policy choices on any given day, in part because no one has a full boat of reliable information on business cycle conditions in the present or near-term future. It’s not exactly flying blind, but it’s close, at least on some days. It’s always obvious what should have been done several months earlier. But as every central banker knows, it’s the present that forever bedevils and plagues the best laid plans of policy choices.

Is Recession The Only Cure For Inflation?
 

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Is Recession The Only Cure For Inflation?

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Comments (14)
gab nea
gab nea Feb 11, 2022 3:44AM ET
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why didn't Powell put the brakes in 2019 and 2020? he didn't want to have a recession then? to appease who? the orange guy?
MuraliKrishna Brahmandam
MuraliKrishna Brahmandam Feb 11, 2022 2:40AM ET
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this low inflation is only Powell transitory, it can go higher. when inflation was 4%, Powell called it transitory, he meant it could go much higher. most people thought otherwise 🧐🤣
Ricardo Diogo
Rcd72 Feb 11, 2022 1:54AM ET
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too much liquidity was the reason and sole reason for inflation.the amount the FED gave to speculate was criminal! in Europe money was given to prevent misery ... in us was just a silly flooding of money. inflated the real estate and from there it spread like a disease....
Chris Poulos
Chris Poulos Feb 11, 2022 1:23AM ET
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so have any of you ever seen asset bubbles burst? cuz youre not acting like it
MuraliKrishna Brahmandam
MuraliKrishna Brahmandam Feb 10, 2022 10:44PM ET
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No matter how much fed will raise rates, this inflation will only be transitory, that is it can go higher
MuraliKrishna Brahmandam
MuraliKrishna Brahmandam Feb 10, 2022 10:43PM ET
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No. Two recessions will be needed. 4 quarterly declines
Andrew Turner
adt_fx Feb 10, 2022 10:31PM ET
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Very Fair Question. One could alternatively ask, Is recession the Only cure for Supply Chain Disruption
Adamo Nals
Adamo Nals Feb 10, 2022 8:58PM ET
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We should already be at 2% on the fed funds rate. And we should be at 4% by the end of the year. For all you younger people there is no fed put. It’s over done with. There will be no reversing course when the market collapses. It’s been 15 years straight up. It’s time. We have 9 trillion on the balance sheet. That is outrageous. 4200 on the S&P is just a start
Chris Poulos
Chris Poulos Feb 10, 2022 8:58PM ET
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4200? youre kidding right? try 1700. were going to hit 4200 next week
Dominic Mazoch
Dominic Mazoch Feb 10, 2022 6:55PM ET
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Maybe the Fed shoukd follow Federal Law and do an Complete Environmental Impact Statement before they change anything. A total EIS covers monetary effects for all. The Fed is setious business, not a Monopoly game.
Bob Ruppert
Bob Ruppert Feb 10, 2022 5:02PM ET
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a recession is the only outcome if inflation has been ignored for too long, as it has been by this administration
Zsombor Komán Birtalan
Zsombor Komán Birtalan Feb 10, 2022 5:02PM ET
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In fact is a heritage of Trump admin started by stupid rate decrease in 2019, continued by stupid relax in 2021 and inexplicable hopes that inflation is just temporary. Lot of mistakes everywhere. Cant believe this guys are the Best in class...
Richie Berg
Richie Berg Feb 10, 2022 5:02PM ET
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Zsombor Komán Birtalan  A stupid person would think that the president of the USA controls interest rates, or that the president of the USA controls federal spending.  As long as democrats and republicans keep everyone blaming the other side, we will never fix real problems, such as the FED printing money.
Zsombor Komán Birtalan
Zsombor Komán Birtalan Feb 10, 2022 5:02PM ET
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he obviosly influenced decision-making, since then the FED lost its pragmatism and reliability, coming with questionable decisions
 
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