Inflation like this can’t last forever. How it will end is now the more salient question. Often it takes a recession to break inflation. Economist Lawrence Summers observed that this has been the case every other time inflation was this high and the labor market was this tight.
Then again, we’ve never before experienced inflation that was caused by shutting off the economy. So maybe this time will be different. There is hope that with some artfully calibrated rate increases and some very, very good messaging, the Federal Reserve can bring inflation down and avoid a recession. The Fed could increase rates just enough to keep inflation from getting worse, and then supply-chain and other post-pandemic pressures will recede and excess inflation will disappear. There already are signs that inflation is moderating.
However, there’s another, perhaps more likely alternative. I call it a bumpy-but-not-a-crash landing. The economy might fall into recession after the Fed pulls back inflation, but it will be a very mild and short one—or even just a few years of anemic growth.
The worry is that inflation is already being baked into higher wages and people expect prices to continue rising. Once wages are spiraling and expectations are set, inflation gathers momentum and is much harder to control. So it’s probable that the Fed’s efforts will lower the heat, but inflation will remain well above the 2% target, maybe 5% or 6% even after the transitory factors play out.
If that’s the case, the Fed will have to consider increasing rates beyond neutral, which could lead to rising unemployment and trigger a recession. Raising rates too late and too much is exactly what caused several recessions in the 20th century. Research from economists Michael Bordo and Mickey Levy argue the Fed caused most of the recessions during the 20th century, and usually it was because they got the timing and the level of rate changes wrong. They see many current parallels to the 1970s. One difference: So far the Fed seems determined to not do anything that will increase unemployment, at least not directly.
But a recession might happen even if the Fed doesn’t raise rates enough to cool the overheated economy. If inflation remains high and wages don’t increase enough to match it (which is the case now), eventually the inflation itself could cause a recession. It acts like a big wage cut to the entire economy and consumption will drop. Inflation also creates more uncertainty and makes dollar assets less attractive.
Still, there are reasons to believe a recession today won’t be nearly as bad as the 2008 recession, or even the one in 2001. Job losses often come as firms pull back on investment and hiring. Firms usually head into recessions riding high, with robust levels of investment and inventories. Once the recession hits, they cut back on spending and run down those inventories.
Not this time. Inventories are already low, and so is investment. The tight labor market isn’t coming from over-investment or a build-up of inventories. Unlike in 2008, household balance sheets are in good shape. People are not over-levered, and many more have savings. One big reason the 2008 recession was so bad was that households started out overextended. It took years for their balance sheets to recover and for consumers to start spending again. Now state and local governments still have pandemic money and can keep spending if a recession arrives. A mild recession might see some increase in unemployment, but not a lot. It may not even be enough to qualify as a recession if GDP growth slows without crossing over into a contraction.
That’s not to say there is no cause for concern. A mild recession won’t be great. Some people will lose their jobs, and it won’t be easy to find another. The stock market may have further to fall, which will make people poorer—especially people who loaded up on riskier assets like individual stocks and crypto. And no matter how mild, recessions tend to hurt low-income people the most; they are most likely to lose their jobs and have much thinner savings.
Recessions always have a human cost. It may be some small comfort, though, that a mild recession in the near term means you can avoid a very bad recession in the future. Severe recessions come from over-levered firms and households investing in assets that go bust. Recessions force bad investments to lose money and firms that were barely hanging on to go under. Taking a longer view, recessions also force capital and workers to migrate somewhere else that may be more productive.