In the world of economics, the possibility of recession and inflation occurring simultaneously has always been a topic of debate. The recent actions taken by the Federal Reserve under Janet Yellen’s leadership have brought this discussion to the forefront once again. While the central bank believed they had successfully overcome high inflation, recent signs indicate a reflation may be on the horizon. This situation mirrors the stagflation crisis of the 1970s, where the Federal Reserve also believed they had overcome inflation, only to be proven wrong.
Inflation is often compared to a chronic disease, such as diabetes. It may not be immediately fatal, but it leads to other problems over time. However, because the urgency of high inflation is not as pressing as that of a recession, central banks tend to prioritize the latter. As long as the risk of recession is evident, inflation is often overlooked.
Yellen has made claims that tightening monetary policy would come at no cost. However, this assertion has proven to be false. Traditional economic theories suggest that insufficient tightening would result in uncontained inflation, while excessive tightening would lead to a recession and increased unemployment. If neither of these outcomes is observed, it does not mean that economic theories have fundamentally changed; rather, it simply means that the timing has not yet been reached. Inflation tends to reappear slowly, making it difficult to detect.
It is possible for both recession and inflation to occur, with recession happening first and inflation returning later. This is due to the fact that recessions are fast-moving indicators, while inflation is slow in motion. Additionally, when a recession is not deep enough, excessive liquidity remains in the system, which can lead to inflation in the next cycle. Conversely, after a financial crisis, inflation may not appear for several years due to the severe impact of the crisis on the economy.
The recent tightening measures implemented over the past two years are likely to have an impact on the real sector, even if they may not be sufficient to contain inflation. This can be seen in the accompanying chart, which shows the year-over-year change of the Federal funds rate (policy rate) on the unemployment rate. The unemployment rate is projected to increase by 2 percent a year ahead, indicating a potential rise in unemployment.
While the risk of increasing unemployment has already been observed in recent data, it is important to note that even a 2 percent rise would not result in a severe recession. This suggests that both recession and future reflation may occur in a cyclical manner, with the two not mutually exclusive. This contradicts Yellen’s claims of a costless tightening and instead suggests a scenario of dual costs.
Reflecting on the lessons learned from the stagflation crisis of the 1970s, it becomes clear that insufficient tightening did not prevent recessions from occurring. In fact, there were four recessions between 1970 and 1982. This serves as a reminder that economic conditions can rapidly change and that vigilance is necessary to prevent future crises.
In conclusion, the possibility of recession and inflation occurring simultaneously is a complex issue that requires careful consideration. Recent actions by the Federal Reserve and signs of reflation have reignited this debate. It is crucial for policymakers to understand that economic theories may not have fundamentally changed, but rather the timing of certain events has not yet been reached. The potential for both recession and inflation to occur in a cyclical manner should not be overlooked, and a dual cost scenario is likely. By learning from past experiences, we can better navigate the challenges that lie ahead.
