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Two Sides of the Same Coin: Inflation and Recession

Humor me while I repeat myself. There are some points worth making more than once. Especially when it comes to inflation, recession, and the stock market.

In my May 2, 2022 Blog, What’s Up with Current Market Volatility, I referenced the following:

We saw more evidence of that volatility on Thursday and Friday of this past week as markets first anticipated, and then reacted to, higher inflation. Investors hoped that inflation would be peaking by now. Instead, the year over year inflationary increase was 8.6%, a forty-year high. While higher prices were concentrated in categories related to energy and food (gasoline, airline tickets, groceries), there were few sectors immune from inflation’s grasp.

Economists’ big fear is that inflation will become increasingly sticky, whereby consumers and businesses will ramp up their buying now ahead of expected price hikes later. We already have way too much demand – witness the backlog for cars, packed flights, and the difficulty finding anyone to provide you the services you need. And we have too little supply, exacerbated by a war that limits basic commodities like oil and wheat. Among consumers, there is little doubt that inflation is the number one problem the country is facing.

I was surprised then this week to read that that a sizeable number of people have told pollsters they also believe we are currently in a recession. Similar polls show that most Americans feel their personal financial situation is quite good, but that the economy is a mess. This is important, because while both inflation and recession are unfavorable, they are not the same.

Inflation and recession are the opposite sides of the same economic coin. Inflation is the result of an economy that is too hot, while a recession emerges when the economy turns cold. In a traditional hot economy, unemployment is low, consumers are flush, and business profits are booming. As the economy heats up, so do prices. If prices get too out of hand, as they are now, we get rampant inflation.

There is a saying that “The cure for high prices is high prices.” That is true, but often consumers do not want to wait for that cure. The Federal Reserve is assigned to step in and help bring those prices down before inflation erodes too much buying power.

On the reverse side, the U.S. economy doesn’t traditionally go into recession without labor market weakness. A recession is characterized by high unemployment, contracting income and spending, and falling business production.  In general, during a recession, many individuals are struggling financially.

Inflation and recession are both part of the business cycle – and as such they are interrelated. Ironically, policy cures for recession can lead to inflation, while different policies designed to reduce inflation can lead to recession. Not surprisingly, the time it takes to go from inflation to recession and back again, is varied and unpredictable.

The chance of a recession in any one year is traditionally around 15%. Because it is very difficult to control high inflation without causing some recessionary forces, the probability has increased.  Consolidating our research, we believe the chance of a recession in the next 18-24 months is anywhere between 35% and 50%. While that number is much more significant than 15%, a recession is not a slam dunk. These probabilities leave the markets guessing.

Why might it take another year or two for a recession to take hold? Because right now the economy is still relatively hot. And inflation’s cure has room to run before forcing a recession.

Just think, if Fed action cut job openings in half, the number of openings would roughly equal the number of unemployed looking for work. In theory, existing jobs would not be lost. And if rising interest rates discouraged some people from buying new homes, perhaps the bidding wars would cease without curtailing house sales too much. Eventually, however, if inflation became too entrenched, Fed policies could tip (or flip) inflation into a recession.

Which brings us back to the markets’ behavior last week. Not willing to wait for concrete evidence of any upcoming recession, markets reacted with fear to the increased likelihood of such an event. But since any recession might be forestalled many months, and might not even happen, the markets retreat should not be deemed definitive. At the same time, we are far from an “all clear” signal.

What might it take to get markets to settle?

  1. A pattern of month-over-month and year-over-year lower inflation numbers
  2. The Fed signaling that rate increases are slowing or pausing
  3. The end of war, or a negotiated peace in Europe
  4. Consumer binge spending waning
  5. Expectations that future prices will be lower, not higher.

Investor patience is likely required in the coming months as we wait for clarity on our economic future. Until recession probability gets much higher or much lower, market sentiment is likely to continue to vacillate, with stock prices rising and falling in alternate succession. In the meantime, the underlying economy will be regrouping and adjusting and preparing for the next coin toss.

 

Betsey A. Purinton, CFP® is Managing Partner and Co- Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com.

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