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Allison Schrager: Nip Inflation Now to Avoid a Worse Recession Later

The choice between inflation or recession is a false one—we must deal with the first to prevent both from growing worse. Americans find themselves presented with a question: Should we suffer a recession to get rid of inflation? The question has been framed as a choice because of fear that the Fed, either out of necessity or by accident, will bring on a recession to slow demand and ease inflation. Former Treasury secretary Larry Summers estimates, based on past inflationary spells, that unemployment will need to go up to 5 percent before inflation comes down. But no choice exists between inflation or recession, either for individuals or for policymakers. Some decline in growth is inevitable. The only choice is how bad it will be.

Many commentators are concerned about the Fed going too far and think that the inflation problem is really due to oil prices, which the Fed can't control. So if the central bank tried to bring down inflation, the argument goes, the costs would be too high. What these critics fail to understand is that we have both supply and demand problems, and they are feeding off each other. Unchecked inflation, even when it is supply-driven, can also cause a recession. Contractionary Fed policy can spare us from a worse recession and some economic destruction along the way.

According to a recent poll, more than half of Americans think that the economy is already in a recession. That is not technically true. There is still growth (we think), and unemployment is low. But it is understandable that people would believe otherwise. When inflation outstrips wage growth, households get poorer. At the same time, uncertainty about how much damage inflation will inflict and what the Fed will do about it is causing asset prices to fall and making households even worse off. The longer this goes on, the more they will suffer.

Suppose the Fed decides not to try to reduce demand, and instead just waits and hopes that inflation goes away as supply-chain and energy issues work themselves out. In that case, the Fed would lose credibility on inflation, and both short- and long-term inflation expectations would either stay elevated or go even higher. Workers would demand higher wages, which would drive higher prices, and wages would go yet higher. Meantime, higher inflation would mean higher interest rates, increasing the cost of borrowing for firms and the government. And the timing couldn't be worse: record-breaking debt and entitlements on the horizon would increase the potential for fiscal stress. And amid rising prices, growth could fall. Governments and households would need to spend less (indeed, households already are spending less). Firms would become less inclined to invest and hire due to the uncertainty. At this stage, if policymakers finally decided to do something about inflation, they wouldn't have the credibility that they enjoy now. That would mean that lowering inflation would require far more than a 75-basis-point rate hike. This is approaching a Paul Volcker–level shock. In that case, we would be grateful for a 5 percent unemployment rate.

That's why it's better to stop inflation as soon as possible. True, in the past the Fed caused several recessions by raising rates too late and by too much. But it is still possible for the Fed to pull off a soft landing and avoid a recession. The central bank is currently on a path to increase rates to a neutral level (about zero, after accounting for core inflation). Rates at this level should not cause negative growth, but even a soft-landing scenario probably means slower growth and higher unemployment. Yet even if we do get a recession, there is still reason to think that it would be mild. Household and firm balance sheets are still fairly strong. But that wouldn't be the case after a long spell of inflation.

While grilling Fed chairman Jerome Powell, Massachusetts senator Elizabeth Warren said: "You know what's worse than high inflation and low unemployment? It's high inflation and a recession with millions of people out of work. And I hope you'll reconsider that before you drive this economy off a cliff."

Warren is right about the pain of high inflation and a recession but wrong about what would cause them. It's failing to raise rates that would leave us worse off–on both counts.

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Posted: July 5, 2022 Tuesday 09:35 AM