The current risk of recession appears to be caused solely by the Federal Reserve's refusal to stop raising interest rates.

When making this decision, the FRB seems focused solely on the risk of inflation. This has the appearance of suggesting that the harms of inflation are far greater than the potential harms of a recession.

On the surface of this, this seems ridiculous. While I hate it when my paycheck gets stretched, I am thankful that I have a paycheck. If I lose my job from a recession, how would lower prices be better than keeping my job and paying more for things.

Inflation seems to my naive viewpoint to be triggered by supply chain shortfalls, OPEC's maneuverings, and the War in Ukraine. Even as inflation gets lowered from the softening of the economy and the increasing interest rates, these same forces are still having an impact with increased energy prices and its effect on other industries.

What is the argument that inflation, as it appears now, is potentially so bad that it is reasonable to further increase interest rates even if it causes a deep recession?


2 Answers 2

  1. First, it is not necessary for Fed to cause recession. Inflation is typically symptom that economy is operating above its sustainable capacity (natural level). Theoretically, if fed is careful with increase in interest rate it can manage so called 'soft landing' when it brings economy to natural level without triggering recession (which would be 'hard landing' see more on this in this Brookings explainer).

  2. When economy operates above its natural rate some correction is sooner or later inevitable. To keep economy operating above its potential Fed would have to ensure inflation actually keeps increasing over time in order to prevent increase in unemployment.

    In long run fed cannot determine the output of an economy (and hence unemployment), these are ultimately determined by real productive capacity of economy over which Fed has little to no control. What Fed can do in long run is just to help determine at what price level that natural level of unemployment will occur. So in long run there is only choice between the same unemployment levels at different price levels.

However, even despite 1 and 2, there is real short-run trade-off between low interest rates and consequently high inflation and lower unemployment. Here there is not much economist can say about what is reasonable. If someone wants to stimulate economy as long as possible at cost of ever increasing inflation to postpone the inevitable then that's valid choice. In US however, voters, through their elected representatives in congress, gave Fed mandate to not just promote full employment but also to maintain price stability. Hence, in US at least it can be argued that voters choose this. This mandate could be change for Fed to care only about unemployment and completely disregard the inflation.


Higher inflation economies seem to have more absolute volatility in their inflation rate. This is confirmed if you look at the inflation rate graphs of Argentina and Turkey. Naturally absolute volatility in inflation is high if mean inflation is high but it seems more appropriate that inflation volatility be a relative measure. If I assume the U.S. will have lower inflation rates than some other countries but higher than the Fed's currently targeted 2%, I want to see what happens to capital investment decisions with a certain constant level of relative volatility in some scenarios.

I supposed a capital project in the U.S. has a total return of 100 dollars in the first year and increases at the expected inflation rate for 4 years at which point the investment is worthless and the equipment is discarded. I assumed that the discount rate is a required real rate of return of 10 percent plus the expected inflation rate. I assumed relative volatility is constant between scenarios and specifically that the inflation rate could be a third higher or a third lower than some sort of mean inflation rate. Perhaps the mean inflation rate can be the result of a central bank target in an imagined future.

The table shows the discounted present value of the project under different levels of expected inflation in the U.S..

sensitivity analysis

There is more variability in the value of this capital project if the mean of expected inflation is high. More variability means the project is less likely be undertaken. One implication is that if relative volatility is a constant, higher expected mean inflation would result in less investment so less output.

If the Fed can eliminate relative volatility and we all get used to 4% inflation or 40% inflation or 400% inflation, this argument that there will be less real output doesn't apply. Whether we can get used to high inflation is another matter and of course there will be other effects such as paying capital gains tax on gains that are "phoney" because they're inflated numbers.


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