Is a recession the price for lower inflation?

It is becoming increasingly clear that high inflation is not going to magically disappear. This raises the question of whether central banks really dare to hurt the economy in order to get inflation under control.

Inflation in the Netherlands rose from 8,6% to 10,3% in July and the inflation record in the United Kingdom also improved again. The only bright spot is that US inflation fell from 9,1% to 8,5%. That surprise added fuel to the fire for the rise in share prices. Investors seem to be prepping that the worst inflationary pain is behind us. In that case, central banks would have to raise interest rates less quickly. Chances are, investors are cheering too early. Both the past and a recent warning from the Bank of England (BoE) indicate that inflation is unlikely to be curbed without taking a knock on the economy.

Interest rate hike is child's play
This is not the first time inflation has taken a turn for the worse. In the 70s in particular, US inflation exceeded 10% on several occasions. I managed to push it down a few times, but each time the relief was only temporary. The turning point came in the early 80s when Federal Reserve Chairman Paul Volcker declared war on inflation and hiked interest rates to more than 20%. In that regard, the interest rate rise of just over 2% since the turn of the year is child's play. Volckner managed to reduce inflation by no less than 6 percentage points. On the other hand, however, the US economy shrank by 2,5% as a result of the harsh interest rate policy.

Beware: a recession is coming
Based on that recession - and other periods when the central bank pushed inflation down in the United States - a dip of about 3% should now be needed. A big difference with previous times is that people and companies have become accustomed to very low inflation over the past decade. As a result, high inflation is less likely to provoke hefty wage demands than in the past. Some economists argue that under current conditions, a 2% recession will cause the overheated economy to cool enough to push inflation down to levels that the Federal Reserve can live with. Across the Channel, the BoE warned in early August that the UK economy would enter a recession later this year.

Pap and keep wet
However, the US central bank is still boldly holding on to a scenario in which inflation can be contained without economic growth turning negative. History shows that the wish is very much the father of the thought. For the US dollar, it need not be a problem at all if the United States ends up in a recession. In that case, the turmoil in the financial markets will increase. That plays into the hands of safe havens such as the dollar. But it is far from that yet. In the coming months, it will be especially interesting to see whether Fed Chair Jerome Powell will fight inflation as boldly as Volckner XNUMX years ago, or whether he opts for a tamper-evident approach.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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