“Recession is when your neighbor is out of a job; depression is when you lose it”,
―Ronald Reagan
Is it possible to return the path of inflation to its goal without causing a recession? The risks induced by anti-inflationary policies have increased, although policy tightening was only one of the factors behind the recessions. However, with the instruments available, central banks should have been able to avoid such recessions.
Recessions are more likely in cycles of higher and longer interest rate increases and higher inflation.
Analyzing 17 cycles of inflation and adjustment, the risks of recession related to high inflation and monetary tightening may be lower today than in previous periods, multiple instruments have been developed so that proper management of monetary policy can avoid.
The danger of central banks pushing economies “to the limit” has been highlighted by the 50 basis point increase in the Fed Rate on May 4, the first increase of that magnitude in two decades.
Larger cycles of interest rate hikes are more likely to lead to recessions. For smaller cycles of 125 basis points or below, recessions occur only about 40% of the time, and for cycles up to 210 basis points, there is a 50% chance between recession and no recession. For cycles between 225-450 basis points, about 60% of cycles result in recessions, but all cycles of 475 basis points or more are inexorably associated with recessions.
There is a clear risk of recession depending on the level of inflation, for maximum inflation rates of 3.2% or less, in five of nine cycles no recession appeared.
For inflation rates between 3.6% and 7.1%, 60% of the cycles were associated with a recession. For the cycles in which inflation rates were 7.3% or higher, only 1 of the 13 cycles avoided recession.
High levels of inflation when monetary tightening cycles start appear to make recessions more likely. Which makes sense, since these cases can be associated with the negligence or inability of central banks, which have acted slowly and allowed inflation expectations to take hold.
For initial inflation rates of 1.9% or less, 6 of 13 cycles showed no recession results, while for initial inflation of 2 to 4% in only 5 of 17 cycles no recession appeared and for initial inflation rates of 5.6% or higher, in only 3 of 12 cycles was the recession avoided.
The best periods to avoid recession were the years of the 1950s, 1960s and 1990s, this last period was associated with inflation targeting policies, with generally low inflation throughout the world, small cycle sizes and many measures of a general nature. “preventive”, to nip inflationary pressures in the bud.
By contrast, all tightening cycles in the 1970s were associated with recessions, most in the 1980s, and in the 2000s.
If we first look at the size of possible monetary tightening cycles, from 2023 to 2025, the rate increases look quite modest: 250 basis points for the US, 140 basis points for the UK, and just 100 basis points for the Eurozone.
Looking only at potential interest rate hikes does not give the full picture, as central banks plan to tighten monetary conditions as well, reducing the size of their balance sheets through quantitative QT adjustments.
The QT of the Fed, the BoE and the ECB in the next cycle amounts to 11%-13% of 2021 GDP, which is equivalent to an additional 70 basis points to 140 basis points of interest rate increases.