At this point, I think all of us have heard of the recession coming our way, whether it be from Warren Buffet telling us to think opportunistically during this fall or Larry Summers asserting that a recession is almost inevitable at this point. However, how is this possible when all prices seem to be on the rise everywhere we look, from eggs to gas prices? How is it possible when employment and consumer spending are still going strong?
Before we dive deeper into the discussion, let’s take a moment to understand the concepts behind recession and inflation. A recession is a drop in economic activity, as measured by the Gross Domestic Product (GDP), for two consecutive quarters. The signs of an upcoming recession include a rise in unemployment and a slowdown in consumer spending. This creates a vicious short-term cycle, as high unemployment leads to decreased consumer spending, lowering sales, and causing a drop in consumer confidence, resulting in people only buying necessities. However, in the long run, a recession can lead to increased spending as the economy recovers and people regain their confidence and financial stability. There is a recovery process to bring the economy to this point.
Fiscal and monetary policies come into play to dilute the damage done and bring the economy back to stability. The government can increase spending to release more money into the market and cut taxes so that households have more disposable income to spend on goods and services. The Federal Reserve Bank also plays a crucial role in the control of a recession through Open Market Operations (OMO). In the event of a recession, the bank would cut interest rates to once again put more money in the people’s hands and execute Quantitative Easing (QE), where the central bank makes purchases to stimulate the economy's activity.
Now, inflation does just as much damage to the economy as a recession but on the other side of the spectrum. Inflation is the result of the rapid growth of prices, higher demand, and oversupply, causing prices to increase, and is measured through the Wholesale Price Index (WPI) and Consumer Price Index (CPI). There are three main types of inflation to be aware of: Demand-pull inflation, Cost-push inflation, and Built-in inflation.
Demand-pull inflation is when the demand for goods and services exceeds the available supply, leading to an increase in prices. If a good/service is in short supply, people generally still pay regardless of the price. Basically, too much money is going after too few goods.
Cost-push inflation, on the other hand, occurs when the cost of production increases, leading to a rise in prices. For example, when there was a shortage of eggs this past year due to a deadly disease among the birds, the cost of an egg went up almost four times the original price. This would result in restaurants upping their prices for any egg-containing dishes.
Built-in inflation results from long-term expectations of price increases. This can occur when businesses and consumers expect prices to rise in the future, and they adjust their behavior accordingly, such as increasing wages, prices, and production costs. An instance of this would be when you anticipate inflation, and you ask your boss for a paycheck boost as you know prices are likely to increase, and you don't have enough in your wallet to cover the expenses.
To mitigate inflation, there are monetary and fiscal policies that limit spending activity and keep the economy smooth. They do the opposite of what we talked about earlier with the recession. Fiscal policies increase taxes and spend less on government purchases, and monetary policies include the central bank increasing interest rates and making fewer purchases. In the short run, inflation can lead to increased spending, particularly on essential items, as people try to purchase these goods before their prices rise further. However, high inflation can also lead to reduced spending on non-essential items as people's purchasing power decreases. In the long run, continued high inflation can lead to decreased spending as people become accustomed to higher prices and adjust their expectations accordingly. This can lead to a lower overall demand for goods and services, and may even result in a recession if inflation becomes too high and the economy cannot adjust.
Now it's time to dig in and figure out what is really going on with the economy. The COVID-19 pandemic has inflicted a severe and long-lasting impact on the U.S. economy, causing disruptions that are likely to persist well into the future. It triggered a sharp contraction of economic activity as government restrictions, such as lockdowns, and the fear of disease spreading kept many people at home. Unemployment rates also increased as the news of the virus became more widespread.
Inflation typically follows a period of economic downturns, and this instance is no different. The first step that brought us here was the government, as well as other countries, giving money to households to help the situation at home and loosen up tight money habits. Once the number of cases waned, restrictions were removed, and people became susceptible to being found outside, driving up demand by a hefty amount. This is what we call pent-up demand. During the peak of the pandemic, people stopped their urges to buy unnecessary items, but once the economy was making its way up, people started purchasing high-cost items. An immediate result of this was demand outpacing supply. Producers were not prepared for the high amount of demand for their products. Companies had a hard time finding employees and returning to the routine they had going before the disruptions. The production costs increased, and so did the prices on the shelves.
On top of all this, the Russian attack on Ukraine in early 2022 impeded the COVID-19 recovery, further pushing us into uncertainty. Many of the world's trading connections temporarily stopped with both Ukraine and Russia. Unfortunately, American businesses depended on many of the products exported from Ukraine and Russia, meaning the toll on them affected the US as well. Though this did not have a significant impact on the US economy like COVID-19, it still played a minor role in the instability of our country.
Inflation and recession are like two sides of a coin that can affect the economy in a cyclical way. In other words, as the economy moves from a period of inflation to a period of recession, it is as if the coin is flipped, and the opposite economic phenomenon takes over. Recession can lead to inflation by creating a shortage of goods and an increase in demand, while inflation can lead to a recession when there is a reduction in consumer spending as a result of increased prices. The current state of inflation and the potential for a future recession are interconnected. The Fed's fight to reduce inflation may push us into a recession. This is why we are hearing various predictions about the economy. It’s a tricky balance, but policymakers use various tools to keep it smooth and avoid this cycle of volitality.
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