Damned if you do, damned if you don’t

Last Updated on Thursday, 4 August, 2022 at 12:25 pm by Andre Camilleri

Silvan Mifsud is director of Advisory at EMCS Tax & Advisory

This is not an easy time to be a central banker. On one hand, central banks need to bring inflation down while on the other hand the tools they have to try to achieve that risk can induce an even larger economic recession. So they are damned if they do not signal that they can control inflation by increasing interest rates and damned if they actually increase interest rates while increasing the risk of pushing the economy into a deeper recession.

Some analysts argue that certain economies, like the one in the US, needs a recession to bring inflation down. I personally tend to differ as that view is way too simplistic. The reality is that today’s inflation is mainly induced by supply issues stemming from the pandemic and the war in Ukraine.

It is true that the present high inflation level brings hardship and hits badly the weakest and most vulnerable sections of our society.  It is a known fact that those with the lowest incomes spend most of it on necessities such as food, meaning that the present price inflation on food is hitting them worse than others.

However, I contend that an economic recession is worse than inflation. An economic recession will ultimately result in lost jobs and hence loss income which would far exceed the extra monthly costs due to inflation. Moreover, the chance of losing your job is not the same for everyone. Research shows that young workers and less educated workers are the most likely to lose their job first.

Some analysts argue that since in various parts of the world, especially in the US and Europe, there is presently a tight labour market, then the labour market is too good and inflation will come down if we have a less tight labour market and we have more unemployed persons. A model developed in the 1950s, called the Phillips curve, predicts that when unemployment rises people have less income and spend less, leading to overall demand falling faster than supply and inflation comes down.

As already outlined there are numerous problems with this prescription as outlined by the Philips curve, in the present situation. It hinges on inflation being demand driven. Some point towards pent up demand due to negative interest rates for so many years and the Covid assistance packages used by various governments. This notion is however not supported by facts. All the economic statistics and analysis around the globe is indicating that the ongoing disruptions from Covid and the war in Ukraine are what is really pushing up inflation.

I recently reviewed an interesting study by Adam Shapiro, an economist at the Federal Reserve Bank of San Francisco, which estimated that less than one-third of monthly core inflation, which excludes food and energy, is due to demand.

Furthermore, there is no increase in the unemployment rate that would produce all the raw materials and food which has supply problems and no economic recession which would solve the issues related to China’s lockdowns or solve the war in Ukraine.

Which brings us back to the difficult position central bankers are in. They can increase interest rates to lower demand and cool off the labour market. However, whether they inadvertently cause a recession or a deeper recession or not, higher interest rates will not fix the supply problems and would probably make some worse by discouraging investments.

We must aim to protect workers and their families and bring inflation down. These two goals seem to be in tension, but they do not need to be so. We surely need innovative solutions which are not based on a complete misunderstanding of our economic challenges today. What is likely sure, is that while we may need many things, we surely do not need an economic recession and surely not a deep and prolonged one.

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