Q+A: How Are Inflation and Recession Linked?

Jul 08, 2023

Increasing interest rates. Rising inflation. Recent bank failures. A down-to-the-wire avoidance of the United States hitting its debt limit. U.S. economic news is bleak.

On a positive note, the May Bureau of Labor Statistics Report released on June 2 showed an increase in job creation.

Do these conflicting economic indicators mean the U.S. is heading toward recession? Marco Airaudo, PhD, professor of Economics in Drexel University's LeBow College of Business, says it's not that simple. He spoke with the Drexel News Blog to explain how these issues are connected and what consumers should do during this time of uncertainty.

That's not a simple relationship.

Usually, we see prices of goods and services growing faster – hence, higher inflation ­– during periods of economic expansions. As average households’ income grows, households experience higher purchase power and therefore demand more goods and services from producers and suppliers, who, if unable to keep up with the pace at which demand is growing, will be "forced" to raise prices.

So, according to this argument, inflation goes hand in hand with booms, not recessions.

This would be the end of the story if policymakers just sat back without taking any action. But high inflation is not a desirable situation because: 1) It eventually erodes households’ purchase power (thus counteracting the boom in income) and 2) it lowers the effective (real) return on financial investments.

Again, policymakers might just wait for inflation to go back to normal, but there isn't any guarantee it will.

In the U.S., the Federal Reserve (the U.S. monetary authority in charge of interest rate setting and money printing) has a clear mandate of "price stability," which translated in simple words says that the Fed should act to keep inflation (on average) around 2%.

What happens is that if inflation is moving above that target (or is expected to be above that soon enough), the Fed usually hikes the "federal funds rate" (FFR). The latter is the baseline rate at which commercial banks borrow/lend cash money from/to each other (at very short term). Think of the FFR as the "baseline cost of getting cash." As the FFR increases, all other rates in the economy adjust upward: credit card rates, rates on consumer loans, mortgage rates, etc., as well as rates on saving/checking accounts or other safe assets (like Treasury bills/bonds).

So, overall borrowing becomes more expensive and saving becomes more attractive.

The two effects combined eventually slow down demand: cash-constrained households will resort less to using credit cards (hence, fewer purchases) and will probably defer consumption to the future (unless strictly necessary), since keeping money in bank accounts offers a higher return. Of course, with mortgage rates increasing, we would also see a slowdown in home purchases.

In principle, this "restrictive" policy pursued by the Fed should bring inflation down to normal (possibly closer to 2%).

The question is: what if the policy is "overly restrictive" (meaning excessive hikes in the FFR).

That's where the risk of a monetary-policy-induced recession comes in. As borrowing becomes too expensive, the contraction in demand by households and/or investments by firms could be so large that it will drive down production – hence a recession!

To some extent this is what we have seen over the last year or so. Inflation went from below 2% to 9% – partly due to higher production costs, supply-chain bottlenecks, etc., but also partly to the sustained increase in demand driven by the post-pandemic Congress/White House's generous fiscal package. And the Fed hiked the FFR from close to 0 to 5.25%.

There are a lot of mixed signals.

The fact that despite rising interest rates, we have not seen one yet and that the unemployment rate remains very low (around 3.5%) is a good sign that the U.S. economy is resilient.

At the same time, we have witnessed unexpected weakness in the banking sector (Silicon Valley Bank, First Republic Bank), the debt-ceiling debate (which came to an end) shows a political divide in the Congress, and political uncertainty at the global level is still unresolved.

I think flipping a coin: "heads, there will be one" or "tails, there will not be one" might be our best forecast. I know it is not an answer, but frankly I do not have a better one.

Spend wisely. Compared to other countries, the U.S. displays one of the lowest saving rates in western economies. On average, U.S. households save around just 5% of their disposable income (income after taxes). About 50% of them do not hold interest-bearing investment accounts (kind of living like hand-to-mouth, they spend what they make). That might be OK if you have good and stable income. But what if you get laid off or just experience a wage cut because of a recession? Or inflation stays at 5% and your wage grows at a slower rate?

Americans have been over-spending, their safety-net is thin and, with the persistent increase in the cost of living, building up a cushion is harder.

Of course, if they completely stopped consuming that would probably trigger a recession. What I am saying is that some more responsible spending is necessary. Economies go through cycles. We had three significant recessions in the last 20 years (counting the pandemic as one, as well). There will be more coming during the next 20 for sure.

I would also add that if a recession comes, given the current public debt situation in the U.S., it would be quite unlikely to see expansionary fiscal packages of a magnitude similar to what we have seen post-pandemic (stimulus checks and the like).

Germany has entered the second quarter in a row with negative economic growth (so, officially a recession). This is clearly not a good sign for Europe, since, in Europe, we (I am Italian) often refer to Germany as the "European locomotive" – when things go well in Germany, all continental Europe enjoys the benefits. As of today, neighboring countries are still managing. But if the situation in Germany persists, quite likely, it will drag the rest of Europe in a phase of negative growth.

The problem is that with high debt and large deficits, all European countries will have few tools to fight a recession. Even less, if inflation remains high (it is higher than in the U.S.), as this will prevent the European Central Bank (the Fed's equivalent in the EU) to eventually cut interest rates.

What is different from the U.S. is the fact that a big driver of this recession is energy. Europe depends on Russian gas (and other sources of energy) more than the U.S. With gas prices skyrocketing (plus the political uncertainty surrounding all Eastern Europe), small businesses have been forced to close (not only in Germany). In Europe, a significant share of production (of both goods and services) comes from small family-run businesses. They are much more subject to the cycle than medium-to-large size firms.

Will this impact the U.S.? I believe not if the recession remains within the German borders. Yes, if it spills over to the rest of Europe. However, historically, a slowdown in Europe has a much smaller negative impact on the U.S. economy compared to a reversed situation (a slowdown in the U.S. usually has significant negative spillovers on western Europe).

I would just add that I do not think we have seen so many different sources of uncertainty and economic weaknesses in the U.S. (but in western economies in general) since the ‘70s. Back then we faced an oil crisis, with the hanging specter of the Cold War. Indeed, inflation was above 10%, rates were way higher than today, and we faced several recessions – four between 1970 and 1983.

Now, we are coming out of a pandemic (a black swan event). We learned all about bottlenecks in the global supply chain. We see a never-ending conflict right at the border of the Western world. We realize that our banking system is still fragile – maybe not as much as before 2007, but still. And the cherry on the cake, we have big fiscal issues to solve domestically.

Media interested in speaking with Airaudo should contact Annie Korp, assistant director, News & Media Relations, at 215-571-4244 or [email protected].

Annie is the news manager who covers business, science and nursing. Her beat also includes the Stephen and Sandra Sheller 11th Street Family Health Services Center and the A.J. Drexel Autism Institute. She graduated from La Salle University and has lived in Philadelphia for nearly a decade. When not writing about Drexel, she enjoys completing crossword puzzles in pen and watching Philly sports. Contact Annie at [email protected] or 215-571-4244.