Credit Sesame analyzes recession and inflation as threats to personal finances. Which is the greatest threat?
What do the following have in common?
- Godzilla versus Mothra
- Terminator versus Predator
- Inflation versus recession
They are all classic “battle of the monsters” conflicts.
Inflation has increased steadily and has established itself as a monster over the last few months. More recently, the possibility of a recession has reared its ugly head.
Independently, these two economic monsters cause problems for the economy. Together, they could wreak havoc. Snuffing out inflation might require a recession. But is it worth it? It’s a question of deciding which is the lesser of two evils, inflation or a recession?
Recession and Inflation: What They Mean
Recession is a period of significant economic loss.
Recession can me measured by the length and/or the severity of the economic losses. For example, the recession triggered by the onset of the COVID pandemic was officially just 2 months long, according to the National Bureau of Economic Research (NBER). And yet, it caused the greatest decline in Gross Domestic Product of any recession over the past 50 years. According to the NBER, there have been seven recessions within the past 50 years.
Inflation is a decrease in the purchasing power of money.
The rate of inflation changes almost constantly with prices declining rarely and holding steady only for short periods. Over the last 50 years, the annual inflation rate calculates to 3.97%. Based on that, for this analysis high inflation periods are defined as times when the annual inflation rate was 4% or greater. By this measure, there have been eleven periods of high inflation within the past 50 years.
Why Recession and Inflation Are Rarely Seen Together
Recession and inflation have somewhat contrary characteristics. As a result, it’s unusual for them to occur at the same time.
Recessions represent a slowdown in economic activity, which suggests weak demand. Inflation, on the other hand, tends to happen when demand exceeds supply.
That’s why people associate inflation with an economy that’s heating up too quickly. In contrast, very weak economies such as during the Great Depression or the Great Recession, have led to periods of falling prices (deflation, the opposite of inflation).
Recession and inflation co-starred in the 1970s
Every once in a while though, things get out of whack. You can have a weak economy and rising prices if there’s an artificial constraint on demand. For example, in the 1970s there were periods of a stagnant economy with rising inflation.
This was known as stagflation. Economic demand wasn’t great, but OPEC oil embargoes caused a scarcity of an essential resource that forced prices higher.
Something similar may explain current conditions. Inflation is rising even as the economy seems to be weakening. That’s because that economic weakness has been accompanied by some artificial supply constraints. These include the war in Ukraine, ongoing COVID shutdowns in China and labor shortages in some industries.
This background is important for understanding the Federal Reserve’s monetary policy decisions this year. The Fed has been raising interest rates in an attempt to slow the economy down.
The idea is that cooling off demand will ease inflationary pressures. The concern is that cooling off demand too much will tip the economy into recession.
Which Has a Deeper Impact?
Is fighting inflation worth the risk of a recession? One way to decide that is to look at the harmful effects inflation and recessions have had in the past.
Recessions mark a decline in economic activity, and the way that hits home most is by costing people their jobs.
On the other hand, inflation robs people of purchasing power. It makes the dollars they earn and the dollars they’ve saved worth less than before.
The following graph is based on recessions and high-inflation periods over the past 50 years. It shows the impact the average recession has had on economic activity and employment, and the impact the average period of high inflation has had on consumers’ purchasing power:
Recessions have been harmful to both employment and overall economic activity. However, these impacts have been mild compared to the damage high inflation periods have done to the purchasing power of consumers.
Which Has a Longer Impact?
Another way to look at the impact of recessions and high inflation is in terms of how long the harmful effects have lasted.
The following chart compares the length of the average recession and the average period of high inflation over the past 50 years:
Recessions are painful, but on average over they’ve lasted under a year. In contrast, when high inflation takes hold it can be hard to shake. Periods of high inflation have lasted an average of nearly two-and-a-half years.
In the end, it’s not just how long the bad period lasts that matters. It’s how long it takes to recover from the damage.
Typically, it has taken 36 months for employment and 20 months for GDP to recover to prior levels after a recession. Purchasing power can never be restored after a period of high inflation.
One of the painful after-effects of a recession is that it can take years to restore the number of jobs that existed when the recession began. Overall economic activity recovers a little faster.
But once purchasing power is lost to high inflation it is never regained. Deflation is so rare that steep price increases are hardly ever reversed. Only one of the eleven periods of high inflation over the past 50 years was followed by a period of deflation that restored purchasing power to prior levels. Most often, once that purchasing power is lost, it is gone for good.
If you wonder why the Fed would risk triggering a recession in order to fight inflation, this historical data provides some answers. Both recessions and high inflation create real challenges for Americans but, generally, high inflation causes deeper and more lasting problems.
You may also be interested in:
- What Do Rising Interest Rates Have to Do with Inflation?
- Highest Inflation Since 1981: What Does This Mean for the People of America?
Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.