Which is the bigger enemy, inflation or recession?

Rises in energy and food prices are the equivalent of a tax rise, so Central Banks need to tread carefully when considering interest rate rises.

| 5 min read

Yesterday US Federal Reserve (Fed) Chairman Powell had to answer some tough questions from Senators. Elizabeth Warren argued that interest rate rises cannot bring down the price of motor fuel or food, and warned him not to raise interest rates too far for too long to “drive the economy off a cliff”. The Chairman stuck to his policy of making it a priority to get inflation down.

The main Central Banks are dusting down their old playbooks after a long period of easy money and unconventional monetary policy. The Fed and many advanced country Central Banks have ended money creation and are raising rates. Their aim is to slow economies, reducing demand which should abate price pressures. They think they will curb even unruly food and fuel prices by reducing spending power. The market debate is shifting to ask whether they will slow things too much by taking rates too high for too long? If they do, slowdowns will become recessions.

Thrifty consumers mean a corporate margin squeeze

The Banks need to keep in mind that the large rise in energy and food prices for most people and for many economies has been the equivalent of a huge tax rise. It takes a substantial amount of money that people and companies could have spent and gives it mainly to foreign-owned companies and governments that control the oil and gas unless the home country produces its own.

Extra tax on the energy is paid to a Middle Eastern or other supplying nation, and the turnover and profit of the supplying company may be largely based and spent elsewhere. Some is an extra tax levied by the country where the fuel is retailed. As the impact is felt this summer, many people and companies will have less money to spend on goods and services in their domestic economies, so overall activity levels will suffer. Consumer behaviour is changing under family budget pressures. Many people are cutting back on discretionary items to be able to afford the basics of heating and eating. Families are looking to buy more value or discounted goods where they have to make purchases as they see more of their net income paid away at the petrol pumps or transferred to their home heating fuel supplier.


This in turn starts to squeeze corporate activity and profits. As companies compete more fiercely to capture what money is available, they need to offer better discounts, special promotions and lower-priced ranges of goods. This results in a margin contraction with companies losing out on both turnover and profit as people seek to spend on a tighter budget. It leads to benefits for the retailers and manufacturers that serve the good value part of the market, and to more competitive difficulty for the higher-priced offers. For some companies, there will be earnings downgrades and profit warnings to come.

How much is enough?

What matters most for markets now is when do Central Banks feel they have done enough to control future inflation? When will they become more worried about the way their present measures will slow economies? They have clearly eliminated much of the inflationary pricing of bonds and shares, which they helped generate by their own purchases of financial assets to try to pump up confidence. They have left the crypto market to struggle with the collapse of liquidity, an obvious sign that things are getting tighter quite quickly. Their further tightening by way of rate rises is beginning to decrease home sales on both sides of the Atlantic, as it cools the mortgage markets. Those on variable rate mortgages will experience a further income loss from the bigger payments. Second-hand car prices are in retreat after strong runs. Various commodities have started to fall away from highs, and even some shipping rates have come down a bit after months of elevated costs and a shortage of capacity.

It seems likely the Fed will stay hawkish for a bit longer as it has been shocked by how far it lost control of inflation this year thanks to past conduct. All the time inflation is running hot month by month they will probably want to go on tightening. Mr Powell is saying he needs to see proof his medicine is working with falls in inflation before he stops the higher rate treatment. The Fed and the Central Banks that follow it have a narrow window to switch from mainly fighting inflation to countering recession.

The sooner the Central Banks think they have done enough to ensure inflation falls next year, the sooner they can start to respond to market worries about recession.

We are watching the labour market very carefully. So far there is still a shortage of people to fill vacancies, but average pay settlements are not yet matching headline inflation nor creating a wage-price spiral. As commodity prices retreat from recent highs those markets may signal a slowdown and offer some relief from further price stresses. The sooner the Central Banks think they have done enough to ensure inflation falls next year, the sooner they can start to respond to market worries about recession.


Which is the bigger enemy, inflation or recession?

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