Will policy tightening tip economies over into recession?

Most developed country central banks are hiking rates more and/or faster than they themselves had previously suggested, like the Fed last week.

However, such actions increase the risks of recession and, with inflation more of a supply problem than a demand issue, some might question whether the banks risk overkill.

Most developed country central banks are hiking rates more and/or faster than they themselves had previously suggested (like the Fed last week), and in many cases by more than markets have been anticipating. But this action raises the risk of recession.

Indeed, for some, such as the UK, the die already seems cast for a period of negative growth. Should these central banks back off and let the downturn/recession do all the heavy lifting when it comes to inflation reduction?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said the inflation is a severe problem and not just a fly-by-night function of temporary post-Covid supply constraints. In addition, the one he wants to talk about today, relates to what’s called the “sacrifice ratio”. In other words, just how much of a reduction in output/increase in unemployment is necessary to bring inflation into line? Central banks will have this equation in mind, particularly the Fed, which has a dual inflation and employment mandate.

Right now, it is particularly relevant in the US and UK, because the labour markets are very tight. In the US, there are around two vacancies for every unemployed person while, in the UK it is around one. These are both extraordinarily high levels in a historical context and suggest that, even if policy tightening tips economies over into recession, it is unlikely to come at a cost of a surge in unemployment.

This is different from the past. For instance, in the 11 US recessions since 1950, the average level of unemployment has risen to around 7.7%. That’s more than twice the current rate. What’s more, even if the unemployment rate rises to 4.1% in 2024 as the Fed expects, this will still be only a whisker away from the Fed’s view of the longer-term “equilibrium” rate. And even if the economy does go into recession (which the Fed does not predict) it seems likely that the unemployment rate will still only go a few tenths of a percent above equilibrium.

In other words, the cost, in terms of rising unemployment, from striking hard against inflation with aggressive rate hikes seems much lower now than it has in the past. In Mr. Steve Barrow’s view, other central banks, particularly the Bank of England, should be looking at things the same way – although he fears that it is not. Of course, no policymaker wants to create economic weakness, worse still recessions and rising unemployment. But if these costs are relatively small compared to the benefit of defeating inflation, then they should– and likely will – be borne by central bankers. They won’t be popular for doing so, but central bankers don’t need to be popular and should resist any political interference if their policies cause recessions and higher unemployment.

Perhaps fortunately, the FED does seem to be backed by the Biden administration, and we can only imagine what might have happened in the current circumstances if Trump had still been in office. In the UK too, the government has stayed out of the monetary debate and, if it has any sense, will continue to do so because any sniff of political interference could hit the pound very hard.

The bottom line in Mr. Steve Barrow’s view is that central banks will continue to surprise on the hawkish side, in part because the costs of going too hard now, in terms of rising unemployment, are not too onerous. In contrast, the strength of the labour market suggests that there could be a much heavier price to pay if central banks go soft on the inflation fight for fear of recession and rising unemployment rates.