Is soaring inflation worse than the recession the Fed may trigger by aggressively fighting it?
Is the cure worse than the disease?
The Federal Reserve is hiking interest rates at its most aggressive pace in decades to bring down inflation that hit a 40-year high of 9.1% in June. The campaign has sharply increased the odds of a recession. A Wells Fargo economist and others forecast a downturn by early next year.
Fed officials acknowledged the risk but vowed not to back off until they’ve reined in soaring prices, effectively saying they would tolerate a slump as part of the trade-off.
“We're not trying to have a recession,” Fed Chair Jerome Powell said in late July after the central bank approved a three-quarters point rate increase for the second straight month. But he noted the path to avoid one “has clearly narrowed.”
The hard-nosed strategy has sparked a debate among some economists: Which is worse – inflation or the recession the Fed may bring about to extinguish it?
There’s no simple answer.
“It’s like saying: Which is worse – a kidney stone or appendicitis?” says Mark Zandi, chief economist of Moody’s Analytics.
And any answer is loaded with caveats.
Fed officials say they can dodge a downturn. A report Friday showed the economy added a booming 528,000 jobs in July, but initial jobless claims – a gauge of layoffs – are rising and job openings are falling, indicating a slowdown is probably coming.
If the central bank did nothing, there’s a good chance inflation itself could spark a recession as consumers and businesses pull back spending, Zandi says.
The Fed’s critics in Congress, such as Sen. Elizabeth Warren, D-Mass., say its approach is misguided.
Though rate hikes can dampen consumer and business demand and lower inflation expectations – a source of inflation itself – they can’t affect drivers of inflation such as supply chain bottlenecks and Russia’s war in Ukraine. There are signs inflation will soon ease, critics say, pointing to falling commodity prices.
Here’s a rough look at which would be worse – today’s 9% inflation or a mild to moderate recession that would push unemployment from 3.6% to 4% and lead to about 4 million net job losses.
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Those who argue inflation is more damaging say:
Skyrocketing prices affect all
“Inflation affects everyone, whereas only some people lose their job in a recession,” says Stephen Miran, founder of Amberwave Partners, an investment firm, and former senior economic adviser at the Treasury Department during President Donald Trump’s administration.
“While it’s terrible if anyone loses their job, the effect is not as broad-based as it is with inflation," he says.
Economists who predict a slide say it won’t be as pernicious or widespread as the COVID-19-induced downturn of 2020 or the Great Recession of 2007-09, which were marked by 22 million and 8.7 million job losses, respectively.
That’s because the pandemic’s effects on the economy have eased and household debt as a share of income is relatively low, leaving Americans in better shape to withstand a setback.
Inflation can be a vicious cycle
“Inflation is self-reinforcing, and if you don’t address it, it just gets worse and worse by itself,” Miran says.
Runaway inflation leads consumers to expect that prices will continue to swirl higher. That, in turn, prompts them to demand bigger pay increases, which causes businesses to raise prices still higher to maintain profit margins, and so on.
Such a wage-price spiral was one of the main reasons for the persistent inflation of the 1970s and early 1980s, which peaked at 14.6% before massive Fed rate hikes triggered a recession and a moderation of soaring prices.
Inflation hurts the economy
Even if steep price increases don’t cause a recession in the short term, they hurt economic and job growth.
Consumers are pulling back spending because their solid wage gains aren’t keeping up with the price of gas, rent, food and other items, Miran and Zandi say.
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Businesses reduce investment because of a cloud of uncertainty: They don’t know when the unstable cycle will end, Zandi says. It all means less hiring and growth.
“Nothing works in the economy without price stability,” Powell said last month.
Those who say a recession is worse argue:
Recession is a bigger blow to output
In a downturn, potential production is lost as businesses lay off workers and cancel projects, says Josh Bivens, director of research at the left-leaning Economic Policy Institute. The Great Recession and slow recovery from it wasted about $20 trillion of potential output, he says.
With inflation, a consumer’s higher prices often translate to more revenue for landlords, oil companies and other corporations, he says. “One person’s cost is another’s income,” he wrote in a blog.
“Recessions lead to a lower level of activity,” Bivens says. “Inflation mostly redistributes money.”
The benefits of reshuffled income are not as obvious. Though consumers often spend their money, companies may dole it out to investors through higher dividends or share buybacks.
Recessions hurt lots of people
Several million Americans may lose their jobs in a downturn, but the effects are far broader, Bivens says. Tens of millions more would see slower wage growth, he says. Others would be underemployed because their hours were cut, or they'd find themselves in lower-level jobs that don’t match their skills, Zandi says.
He estimates that 10% to 15% of workers would lose their jobs or face underemployment in a recession.
There may be long-term scarring
A recession might affect fewer people, but the impact of each job loss would be much more severe than higher prices, hurting the ability of many unemployed to pay basic expenses.
Layoffs can result in long-term unemployment for some workers that can erode skills, lower wages and cut short career paths, Bivens says.
Young adults who graduated college during a recession suffered earnings declines lasting a decade, and some were permanently affected, according to a study published in 2012 in the American Economic Journal.
Zandi figures the economic toll from severe inflation and a typical recession would be about equal.
“They’re both bad,” he says.
Paul Davidson is USA TODAY's senior economics correspondent. You can follow him on Twitter @PDavidsonusat and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.