Previously published on May 22, 2022 in
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By Milton Ezrati, Chief Economist at Vested

Recession is in the cards and not because of the recent report of declining real GDP in the first quarter. That was more the product of statistical particulars than anything fundamental. A real recession looms nonetheless some months out because of the tremendous inflationary pressure confronting this economy. Only in the extremely unlikely event that price pressures lift mysteriously of their own accord can the nation avoid this unwelcome prospect. And since inflation’s roots run deep in the economy’s fundamentals, such luck is far from likely.

The recession will have one of two causes. If the Federal Reserve (Fed) decides to exercise sufficient monetary restraint — restrict credit flows and raise interest rates considerably and rapidly — it would likely shock markets and precipitate recessionary conditions, perhaps brief and mild, but a recession, nonetheless. The Fed could, of course, avoid taking aggressive action. That might delay recessionary pressure, but eventually an unchecked inflation itself would produce sufficient economic distortions to bring on a recession anyway, probably more severe and longer lasting than one induced by anti-inflation policies. One way or another, recession looms.

This ugly prospect confronts the country because, contrary to Washington claims, today’s inflation is neither “transitory” reflection of post-pandemic strains, nor the immediate result of the fighting in Ukraine. Though these developments surely have contributed to inflationary pressures, today’s price pressures have a more fundamental and persistent cause. They reflect no less than a decade during which Washington – under both Democrats and Republicans — has run huge budget deficits that the Fed has financed by creating a torrent of new money, with the Fed buying some $5 trillion in government debt over the entire time, some $3 trillion in just the last couple of years. This modern equivalent of financing government by printing paper money is a classic prescription for inflation.

The Fed has begun to correct this behavior. It has increased interest rates and recently reversed its quantitative easing program. Instead of using newly created money to buy bonds directly on financial markets, it will withdraw liquidity by selling some of the securities it has amassed in prior years. It will have to do more to deal with inflations, selling more securities and raising interest rates much faster and farther. Consider that short-term rates, even after the Fed’s latest move, still stand at 1.0 percent. In today’s 8.3 percent inflation, a borrower will repay the lender in dollars that are worth that much less in real terms. Since that borrower only pays 1.0 percent for the use of money, a huge incentive to borrow and spend remains. To erase it and blunt inflation, the Fed will have to raise interest rates above the ongoing rate of inflation. Getting there quickly enough to have effect will inevitably shock markets and the economy, almost surely enough to cause a stall in economic activity and likely a brief downturn.

But even if fear of such economic pain prompts the Fed to go easy, the recession will come. Eventually unchecked inflation itself will make business planning so fraught with uncertainty that businesses will forgo investment projects that would otherwise enhance the economy’s productive potential and encourage job growth. Also as is already evident, workers, even if able to secure wage hikes, will still struggle to keep up with the rapidly rising cost of living and cut back their spending accordingly. By eroding the value of dollar-denominated assets, like stocks and bonds, inflation will also cause a retreat in financial markets and in so doing further discourage investments in real productive capacities. At the same time the inflation would redirect what investment monies are available into inflation hedges, such as art and land purchases, instead more productive activities. All these distortions will bring on recession even if the Fed fails to act, perhaps a more severe and long-lasting one.

The recession now in the cards, might have been avoided. Had Washington acted instead of dismissing inflation when it first appeared a year ago, the authorities would not now have to shift as radically as they do to have sufficient anti-inflationary impact. Instead for months, Fed Chairman Jay Powell insisted that the inflation was “transitory,” as did Treasury Secretary Janet Yellen. Even President Biden, as late as last summer, made such claims. Now the White House blames Vladimir Putin. Prompt action could not have avoided all the inflationary pressure, but it could have eased the intensity of the trouble the U.S. now faces. That opportunity is, of course, now gone.

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