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Inflation Soars To Highest Level In 40 Years As Recession Risk Rises

The Bureau of Labor Statistics released its May report on inflation, which increased 8.6% on an annual basis. This is the highest reading since December 1981 when Paul Volker was Chairman of the Federal Reserve and Ronald Reagan was president. Why is inflation running so hot? What will it take to bring it down? Will the U.S. enter a recession?

Why is Inflation so High?

Inflation occurs when demand exceeds supply. While that is the case this time as well, the causes are vastly different from any other time in U.S. history. It all began when the pandemic struck. Without government intervention, the pandemic would have caused a severe recession, some suggest a depression. How did we avoid a severe recession?

In 2020, the Trump administration and Congress passed a series of stimulus bills with a total price tag of just under $3.7 trillion. When President Biden took over, his administration and Congress passed additional stimulus of $1.9 trillion. Combined, Washington has passed nearly $5.6 trillion in spending bills associated with the pandemic. The Fed has also chipped in with aggressive monetary stimulus of its own. The point? During the past two years, the federal government along with the Fed have added an enormous amount of monetary stimulus to the U.S. economy. This stimulus led to a booming economy, although it didn’t help everyone.

Then came the disruption of the supply chain and subsequent war in Ukraine. On the former, companies couldn’t find enough labor and materials and all facets of the supply chain (ex: source product, manufacturing, distribution, etc.) were disrupted. When Russia invaded Ukraine, oil prices spiked, leading to record high gasoline prices. The Russian invasion also contributed to a shortage of seed oils, corn, and wheat, three of Ukraine’s largest exports. While the price of these food products has risen significantly, higher gasoline prices and a shortage of workers are likely contributing to overall food inflation. Thus, the combination of an excess amount of monetary stimulus and the lack of supply has led to one of the greatest supply-demand imbalances in U.S. history. The result? Moderately high inflation.

What Will it Take to Bring it Down?

To reduce inflation to a manageable level, two things must happen. Supply must increase and demand must decrease. However, with a growing number of businesses warning of an economic downturn, how much can supply increase? If businesses, many of which are already struggling with excessive inventories, fear a looming recession, they will not rush to add supply. Thus, even if the supply chain problem ended soon, it is unlikely there would be enough businesses willing to spend on additional product, except of course for essentials like food, gasoline, and such.

How do you reduce excess demand? Enter, the Federal Reserve. The Fed, which was late to act, has announced a series of rate hikes designed to raise the cost of borrowing in an effort to reduce demand. The Fed has also announced it will reduce the amount of monetary stimulus it is adding to the economy. If the Fed’s plan to reduce demand is successful, and demand doesn’t fall too much relative to supply, the economy will have a soft landing, meaning we will avoid recession. Will this be the case? Will we have a soft landing, or will a recession occur?

Will the U.S. Enter a Recession?

A recession happens when the economy contracts for two successive calendar quarters. In the first quarter of 2022, the economy (GDP) declined 1.6%. If we see a similar result for the second quarter, this will meet the classic definition of recession. Will the U.S. experience its 16th recession since the Great Depression? Probably. It is highly unlikely that the Fed alone will be able to bring demand down to a normal level relative to supply. It will also depend on the Biden administration and Congress.

Who’s to blame? If you watch Fox News, everything is the fault of the Biden administration and democrats in Congress. If you watch the other side, it’s the pandemic and Russia, and republicans when they were in office. What’s the truth? If you remove politics from the equation, the real reason for this 40-year record high inflation is the pandemic, the Fed’s inability to act sooner, Russia’s invasion which created an oil shortage, which pushed gasoline prices higher, and both parties in Washington. The complexity of this issue does not lend itself to media-biased sound bites. Don’t expect much of the media to provide both sides of the argument. After all, it is an election year.