The question is which is the bigger evil, inflation or recession
By A. D. Amar, Ph.D.
On the afternoon of May 3, 2023, the Federal Open Market Committee raised the interest rates by 0.25%, bringing the federal-funds rates, considered the base for bank interest rates, from 0.08 to 5-5.25%. The Fed’s goal is to slow down the economy by reducing the overall demand which will force the market to cut down the inflation rate to a level which they call their “mandate rate,” – 2%.
This increase in interest rate marks the Fed’s tenth straight increase since March 2022, when it was at 0.08%, bringing it to the highest interest rate in sixteen years. While the Fed hints that this hike may result in a pause, the reality of the economy tells us otherwise. The current inflation rate, which is at 5%, is not going down to 2% or even 3% by June 2023 when the Fed’s next interest rate meeting is scheduled to take place.
Looking at the past interest rate increases that were made in an attempt to cut inflation, we find that recessions succeeded them almost always. Therefore, we can easily assume that some kind of a recession is brewing. The Fed will achieve its mandate but at the cost of a recession. It is like trading one unwanted outcome for the other. Simply restated, bring recession and cut inflation or tolerate inflation to avoid recession.
While many believe that tolerating inflation raises it higher and higher, in my opinion, and there are many others of the same belief, we should give a greater importance to employment. The policy of intervening in the economy to slow it down by increasing interest rates is not right for the public at large.
Then, the consequence of these increased interest rates hits banks because they have their holdings in financial instruments whose value goes down when interest rates go up. Currently, these moves by the Fed have resulted in the collapse of several midsize and regional banks. Most notorious among them are Silicon Valley Bank and First Republic Bank. It is feared that more banks will follow them.
The question is which is the bigger evil, inflation or recession. When we look at the dilemma from a social perspective, we see that higher interest rates hurt the general population more than the economic harm that comes from an inflation rate that is greater than 2%. Increases in interest rates to reduce inflation by slowing down the economy bring about job loss and higher unemployment rate.
The current number of job openings has gone down to the lowest since 2021. The number of layoffs and discharges rose to the highest level since 2020. The loan rejection rate is at the highest level since 2017. The state of the American economy is currently not healthy.
When people don’t have jobs, they do not buy, squeezing sales everywhere. This is what results in a deep recession. However, the Federal Reserve will be happy, touting it achieved its 2% inflation rate. Good for those who have jobs but misery for a large mass of people without them.
If people can keep their jobs in an inflationary economy, even when their wages do not keep pace with inflation, they keep up by cutting back on some of their purchases. But, if they lose their jobs, they basically cut back on almost all of their purchases except the essentials, bringing a deeper, long-lasting recession.
Currently, we could already be in a recession but may not know it for some time. Nevertheless, the economy is definitely on the edge which, given the current Federal-funds rate, is going to cause a mild recession. Any further increase will add to the American public’s misery rate—the sum of inflation rate and unemployment rate. And, since the interest rates on mortgages, auto loans, finance charges on credit cards, etc. all over the world, to some extent, are impacted by what the Fed does, this misery spreads to the world population.
In support of maintaining a policy that tolerates inflation when it goes higher than the Federal mandate rate of 2%, let me present the case of Procter & Gamble Company, America’s largest consumer goods company that produces Cascade, Pampers, Tide, Gillette, etc. stated that when it increased prices in a high inflation economy that we had been going through, people bought more of its products, resulting in even higher sales and higher profits, according to the company, reporting for the last two consecutive quarters, ending with March 2023.
If all we were doing was to manipulate interest rates to hold inflation at two percentage points, then why wouldn’t we leave it up to a computer and an AI algorithm rather than giving the task to the super-smart humans running the policy at the Federal Open Market Committee (FOMC)?
Dr. A. D. Amar is a Professor of Management, Stillman School of Business, Seton Hall University, South Orange, NJ 07079.
Disclaimer: The views expressed are not necessarily those of The South Asian Times