Do We Need Recession to Cool Inflation?

Last Friday, a paper presented at a high-profile monetary policy forum in New York found the Fed needs to induce a recession via rate hikes in order to tame inflation. The paper, written by a group of economists for the University of Chicago’s annual get-together, comes as fears grow that the economy is doing too well—running hot—showing the Fed needs to act much more aggressively. But a look at the paper shows why investors shouldn’t take those views to the bank.

Here is how the paper put it: “... there is no post-1950 precedent for a sizable central-bank-induced disinflation that does not entail substantial economic sacrifice or recession ... simulations of our baseline model suggest that the Fed will need to tighten policy significantly further to achieve its inflation objective by the end of 2025.”^[i] Coverage then pronounced game over. One headline declared, “Fed needs a recession to win inflation fight, study shows.”^[ii] Another posited that, “Fed’s rate hikes likely to cause a recession, research says.”^[iii]

But before you nod along, consider the data and methodology. While it uses disinflationary episodes in the US since the 1950s, for Canada, Germany and the UK—comprising 10 of the 17 periods sampled—it looks only at the 1970s onward, skewing the dataset heavily towards the mid-1970s and early-1980s. It also omits the mid-1990s’ and mid-2010s’ disinflations. Perhaps they weren’t big enough. But that means the data basically feature one global episode of hot prices. Notably, Japan wasn’t included, either, “due to the exceptionally modest fluctuations in the unemployment rate.” Which highlights what drives the model: “measures of labor market slack.” It relies on the supposed relationship between unemployment and inflation—the Phillips curve—and another theoretical construct called the output gap. But both are suspect.

The Phillips curve assumes inflation is tied inexorably to employment. It argues that low unemployment signals a high-pressure economy, which spirals prices higher. Workers empowered by scarcity demand higher wages, which companies pass on to consumers—lather, rinse, repeat. So a central banker wanting to slow prices would have to drive up unemployment. That may sound logical, but it hasn’t worked out that way very often in practice.

Consider the 1970s, when high inflation coincided with high and rising unemployment. Or, more recently, the 2010s’ low-unemployment and low-inflation expansion. There isn’t a relationship because inflation is a monetary phenomenon—too much money chasing too few goods and services. Labor markets may play into this. But they aren’t essential to it, in our view. As Milton Friedman taught years and years ago, wages generally follow inflation—they usually don’t lead it.

The same goes for the output gap, which is based on estimates of potential GDP—if all the economy’s capital and labor were fully employed. If the economy is growing below potential, supposedly, no inflation. If above, inflation. Problem is, like the Phillips curve, it doesn’t work. The Congressional Budget Office (CBO) puts out among the most widely cited output-gap measures, but even these are just educated guesses. No one really knows how accurate the models used are in real time. The CBO’s have given many false signals since the 1970s. Above-potential readings in the early-2000s and 2005 – 2008 didn’t bring hot inflation. And perhaps more damningly, except for one quarter being 0.5% over potential in Q4 2021, GDP has been under estimated potential output throughout the current inflationary episode.^[iv]

We see little evidence increasing the unemployment rate—or output gap—brings down inflation. Hence, the idea a recession is necessary to cool prices now seems off to us. Furthermore, consider: The chief driver of slowing inflation, in our view, is cooling money supply growth. And that has happened. M2 growth has already slowed globally, to the point of turning negative in America. The Divisia M4, the broadest measure of money supply, is flattish. And, beyond money, consider: Myriad other input prices—from oil to grains to shipping and more—are well off their highs. As these feed through the economy, it is likely prices will cool—regardless of what the Fed does. Maybe the quote we shared earlier is a hint at that outcome. After all, it said, “there is no post-1950 precedent for a sizable central-bank-induced disinflation.” (Emphasis ours.)

Of course, this isn’t to say the Fed won’t induce recession. We question the central bank’s ability to do so via traditional rate hikes right now, given a flood of deposits renders interbank borrowing—its chief channel to influence credit and inflation—rather moot. But maybe the Fed and other central banks take more radical action, like reimposing reserve requirements suddenly and drastically. That could freeze credit. But the idea the Fed must force contraction to cool prices seems to commit the same error central bankers made in 2020—overreacting.

So will the Fed keep hiking until there is a downturn? Who knows. It has screwed up before. But necessary and automatic? Seems like an overstatement.