Why A Recession Now May Mitigate Higher Long-Term Inflation Later

The Federal Reserve is facing some critical decisions that will likely dictate the direction and pace of the economy over the next several years. Our view of the optimal scenario is where the Fed taps the economic brakes just enough to snuff out persistent inflation, but not so much as to cause a recession – a so called soft landing. That is a very tall order. We believe if they err, it will be because they are too aggressive in addressing inflation, which will likely bring on a recession. Persistent inflation is a disastrous alternative as compared to a temporary recession.

Our excessive economic response to the pandemic has caused the inflation problem.
The Fed is committed to fixing it and has the tools to do it, but it is unlikely to be pleasant.
Inflation will calm down, but we will be starting from a new, permanent higher price level.
There is increasing risk of a recession, but that is a better option than persistent inflation.

Too Much Money Chasing Too Few Goods

The pandemic catalyzed an economic scenario that we had not seen in over one hundred years and the economy of today is vastly different than one hundred years ago. As such, there was not much of a playbook to follow when COVID hit home. The economy quickly collapsed under imposed and voluntary shutdowns. The Federal Reserve acted, as always, to ensure markets functioned by making monetary policy massively accommodative, but the Fed has effectively no ability to help the populace directly. That job belongs to Congress and our fiscal policy. In a series of legislative actions, Congress initiated numerous programs to help average workers and businesses manage their way through the pandemic.

However, there were consequences, outlined in a quote from Milton Friedman 50 years ago: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” It still rings true today as we see in our current inflationary environment in the US and globally.

We were unprepared for the pandemic, so the reaction was extreme and, in the end, excessive. The resulting evidence is the current rate of inflation. Money Supply, as measured by M2, had been growing at a mid-single digit rate since the Great Financial Crisis (GFC), but the response to the pandemic quickly changed that to a mid-twenty percent growth rate. Two years later, growth in M2 has receded, but it is still as high as it has been in the last 40 years, except for the heart of the pandemic. Put simply, what we are experiencing is too much money chasing too few goods.

M2 is a measure of the money supply that includes cash, checking deposits, and ‘near money’ which is anything that can be easily converted into money.

Is It a Supply Problem or a Demand Problem?

We hear lot about supply chain disruptions and lines of container ships waiting to dock. Unless one is paying close attention, it would be easy to believe that the pandemic has slowed operations down causing the supply shock. In many ways, it has been just the reverse. The Port of Long Beach and Los Angeles handled 10.7 million containers in 2021, up 14.3% from 2019, before the pandemic. In fact, the number of containers handled in 2020, the heat of the pandemic, was only 1.3% less than in 2019. So why the supply problems?

The real issue is that the supply chain has been unable to keep pace with a sudden, exceptionally large increase in demand. The initial transitory theme of inflation was predicated on the belief that the demand surge would calm down quickly as the pandemic faded. That has proven incorrect.

When we shut down human contact, the services economy came to a screeching halt, but all the money provided by the government resulted in skyrocketing demand for goods. The chart below shows Durable Goods expenditures beginning in 2009 as we exited the GFC (green line). Since that time and until the pandemic, the trend in durable good expenditures was remarkably consistent, as shown by the brown dotted line which extends the pre-pandemic trend. The blue line is what happened in response to the pandemic, reflecting the massive amounts of money poured into the economy to offset the initial crash. In December alone, expenditures on durable goods were an estimated $345 billion, or 21%, above what was expected if we stuck to the old trendline. No wonder suppliers have been unable to keep up.

One thing we can be sure of is that a trend that cannot sustain itself will eventually end. Spending at this rate is not sustainable. The fiscal stimulus Is now effectively gone, and incomes are growing at a much slower rate than expenditures, so this is clearly an unsustainable trend. Inflation calms down when our current lust for goods subsides. It has been labeled a supply chain issue, and the Fed is unable to address supply issues, but the Fed CAN affect demand and less demand is precisely what we need, no matter the catalyst. The Fed is now clearly signaling that they intend to be that catalyst by raising interest rates and beginning to unwind the bond purchases that have supported the economy for so long. The gradual run-off of the pandemic fiscal stimulus and a less accommodative monetary policy by the Fed will slow the growth of M2 and begin to crimp demand.

The transitory inflation story long espoused by the Fed and many on Wall Street is now dead. We are confident that in the end, we will not see a persistent inflation like the 1970’s, but we won’t get back to ‘where we were’. We will simply begin anew from a higher price level. The bond market appears to agree with this assessment as 5-Year, 5-Year forward inflation expectation rate is just above the Fed’s 2% long term target. (The 5-Year, 5-Year forward rate is a measure of expected inflation, on average, over the five-year period that begins five years from today.)

The Fed’s predicament:

If they are not aggressive enough in addressing inflation, inflation expectations rise and inflation can become more ingrained. On the other hand, if they are too aggressive, they will certainly fix the inflation problem, but it will come at the cost of a recession. Neither of these scenarios is ideal.

While a short, shallow recession would be painful, it would also hasten a return to normal for the supply chain and ease inflationary pressures. Once corrected, we would expect a return to a more normal economic cycle. Persistent inflation over the longer term is much more disruptive. It tends to change consumer habits and subsequently requires a much stronger solution, as it did in the early 1980’s. Although it would have the benefit of making our excessive debt a bit easier to repay, it would come at the cost of further widening the gap between the haves and the have nots. It is the poor that suffer the most from inflation. In our view, long term, inflation is a much worse alternative than a temporary recession.