Is recession the only remedy for inflation in the United States?

Is recession the only remedy for inflation in the United States?

The specter of a recession hangs over the United States, an evil that could prove unavoidable to save the world’s largest economy from inflation. This assumption is gaining momentum after the central bank’s historic decision to raise its key rates sharply.

“The chances of a recession in 2023 increase because it may be necessary to control inflation,” said Joseph Gagnon, economist at the Peterson Institute for International Economics (PIIE), and former Fed economist, in a note.

The US economy has already slowed with a 1.5% contraction in GDP in the first quarter. The start of the second quarter seems to show that the slowdown is continuing in certain sectors such as manufacturing, real estate and retail sales.

Great ills require great remedies: in the face of ever-increasing prices, the economy must be slowed down, as demand from American consumers remains strong and supply insufficient.

“Purchasing power must align with supply,” Steve Englander, head of US macro-economy for Standard Chartered, and former economist at the US central bank (Fed), told AFP.

And that is precisely the job of the Fed. By raising its key rates, it encourages commercial banks to offer more expensive loans to individuals and businesses, which are therefore less inclined to consume.

– Soft landing pulls away –

Inflation having broken, in May, a new record in 40 years (8.5% over one year), the institution therefore proceeded, on Wednesday, to the largest increase in its key rates since 1994: it raised them by three-quarters of a percentage point, to bring them into the range of 1.50 to 1.75%.

This third increase will be followed by other strong increases by the end of the year.

“Let’s be clear, we are not trying to induce a recession”, nevertheless assured the chairman of the Fed, Jerome Powell: “we are trying to bring inflation back to 2%, (and keep) a strong labor market.

The Fed is now counting on 5.2% inflation this year, when it still anticipated 4.3% at its March meeting. At the same time, it forecasts growth of only 1.7%, against 2.8% previously.

“The risk of recession is increasing, and sharply,” said Steve Englander who, however, thinks that this scenario should be avoidable.

However, the “soft landing” that Jerome Powell promised a few weeks ago, now seems very difficult to achieve.

“The prospects for a soft landing look increasingly less credible, and we now judge a recession next year to be more likely than not,” warns Jay Bryson, economist for Wells Fargo.

Indeed, he explains, “inflation is setting in (…), eroding real income, which will probably weigh on the growth of consumer spending in the coming quarters”.

In addition, the Fed’s sharp rate hikes “will eventually weigh on interest-rate-sensitive spending,” that is, purchases made on credit. Many of which are in the United States.

– A “Goldilocks” economy –

The venerable and powerful US Federal Reserve, however, is willing to take that risk to prevent high inflation “persistent for many years to come”, notes Kathy Bostjancic, chief economist for Oxford Economics.

Ideally, the American economy should follow a trajectory, known as “Goldilocks”, named after the children’s story, she explains to AFP. In other words, an economy that cools just right, at the right temperature, like the little bear’s bowl of soup, which the little girl gobbles up in the story.

The consumer frenzy experienced by the country for nearly two years, thanks in particular to the generous financial aid paid by the government, has come up against struggling production, due to the global supply difficulties that have persisted since start of the Covid-19 crisis.

As a result, prices skyrocketed.

And the war in Ukraine added an extra layer. Soaring oil prices, in a country where cars are often essential and fuel-hungry, are weighing heavily on households, as are rising food prices.

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