Recession fears in the wake of rising interest rates and high inflation have been the name of the game for the first half of this year. It seems increasingly likely that the US, the UK, and Europe will end in recession if central banks hike too much – and I think for now they are on a path to hiking too much.
One of the key problems I see with central bankers today and with many pundits who say that central banks have to fight inflation with all they have is that they fail to differentiate between supply-driven and demand-driven inflation. Supply-driven inflation from supply chain disruptions or boycotts of energy exports cannot be tamed with monetary policy measures. These supply-driven events act as a tax hike and I don’t think anyone would appreciate it if central banks would hike interest rates to fight inflation caused by a 5% increase in VAT.
But too many central bankers seem to be unable to make that differentiation, though there is increasing realisation among policymakers that they are unable to fight the current inflationary shock with monetary policy. Yet, they are adamant in hiking rates fast. And that might create a recession.
But in a recession, not only would we see central bankers slash interest rates again, but we might also see calls for new fiscal stimulus through tax breaks or government support for working class families and the unemployed. The problem may be that compared to previous recessions, this government support might be less effective. Mario di Serio and his colleagues have examined the fiscal multiplier of fiscal stimulus in 10 Eurozone countries and differentiated between supply-driven recessions, created by high inflation and demand-driven recessions created by waning demand leading to low inflation. Now, because this is a study of Eurozone countries, there is a bit of a caveat. The Eurozone has been so different in the last decade or so from the US or the UK, that I am not sure if all the results for the Eurozone hold there as well. But at least qualitatively, the study can give us an indication of the problems governments may face in stimulating the economy in the next recession.
And qualitatively, the results are pretty clear. In a supply-driven recession like the next one (if we get one, that is) the fiscal multiplier of government spending is generally less than half that of a demand-driven recession. Or to put it the other way round: in a supply-driven recession, governments need to spend two to three times as much money to get the same effect on growth as in a demand-driven recession. This, in turn, means that if we drop into recession, the way out of it will likely be slower and may take longer than what we are used to from previous recessions.
Government spending multipliers in a demand-driven recession are 2-3x higher
Source: di Serio et al. (2022)
Completely agree, I have been hoping and praying these last few months that central bankers are just jaw boning and don't really believe their own pronouncements. Recent behaviour by them though indicates this is not the case, this means the risk of recession is increasing dramatically.
The only caveat, and where they might be right initially, is there probably was a fair bit of demand driven inflation due to the unprecedented fiscal stimulus throughout the western world. Of course that stimulus is now gone but the historical inflation numbers remain. Therefore in the end, they will wrong anyway as demand driven inflation fades with falling stimulus.
Nevertheless I have the distinct impression recession is coming. Possibly US first (unless Putin turns off the gas), then Europe (if he doesn't) and finally Australia, Canada and NZ after that.
Grrrrrr
I just read the news that Bank of England governor Andrew Bailey is threatening to increase the interest rate by by 0.5%. While he is not a economic genius (after his poor performance at the FCA), I am wondering why is every Central Bank rushing to increase rates if it is not effective to control supply side inflation? Is it that they do not have any other tool in their arsenal, so they just try what they can do? Or is there some disadvantage if one Central Bank acts contrary to what every other Bank is doing, so there is a herd effect? Or is it just the pressure to conform that is driving every Bank to do the same (wrong) thing?
While on Andrew Bailey, he was recently advising people to not ask for pay raise. Is this also a strategy for demand-driven inflation that is being deployed in the wrong battle?
I am not an economist, so I am not sure how the whole thing operates!!