State of the economy: Inducing a well managed recession is the need of the hour

According to google, the searches for the word “inflation “ has surged this year globally. Consumers are googling for inflation more than at anytime since 2008. There is no doubt that inflation has become a real cause of pain for families across the world. For example, inflation is costing an average US household an extra $ 341 a month and more. And the situation is far worse in other countries including developed as well as the developing world.

The question one may rightly ask is, how did we get here ? And most importantly, what the road ahead looks like ? Now, the answer to, how we got here part is quite easy. The unprecedented amount of Covid relief measures announced by governments globally was bound to create inflation. The sudden surge in demand while the production capacity remained low, because of lockdown measures, had to disrupt the supply chain. And without the supply keeping up with the demand, the prices had to go up. Also, the war in Ukraine has obviously made a bad situation worse.

But let’s not forget that to a large extent the current situation is self inflicted. As some would say, the central banks should have done a better job, and probably they could have, but policy makers were bling sighted by the covid induced pandemic. It was quite hard for anyone to see the impact of emergency half baked policy measures that were implemented to rescue the economy from a free fall during the lockdown.

When governments decided to get involved in money creation by offering guaranteed loans to companies, individuals through banks on top of providing generous furlough incentives. They couldn’t foresee the disruption and impact of such measures on the economy going forward. Central banks are only human, and they had no way of assessing if the disruption is transitory or a changed economy. Having said that, the signs were there. I was expecting policy mistakes, and why wouldn’t you, if you are operating in unprecedented times without a reference then mistakes will be made. It is a quite natural expectation.

While inflation is painful to the society, it does make it easier for government to pay debt. Higher inflation increases nominal tax revenues, for example, if prices are higher then the government will collect more VAT, also workers do end up paying more income tax. High inflation can reduce the real value of debt, bondholders on fixed interest rates will see a fall in the real value of their bonds and it becomes easier for the government to pay back these bonds. High inflation can enable the government to freeze income tax thresholds so more workers pay higher tax rates – it becomes a way to increase tax revenues without increasing tax rates. Generally, in an inflationary environment, the government as a borrower is better off, bondholders ( the savers) are worse off as a result of inflation.

You could conveniently blame the central banks for getting this wrong, but that’s missing the big picture. The ongoing war in Ukraine also had an impact. And in response, by weaponising finance against Russia, there is no doubt that we did give inflation a longer runway. I do wonder if governments understood the ramification of their actions? Perhaps, not. I am quite inclined to believe that the officials didn’t really grasp the big picture. But I am not sure if they should be blamed for it, they had to make do of whatever they could come up with, and that’s the problem here.

Coming back to inflation and the state of the economy. I am not expecting a wholesale crash. Also, contrary to the popular view, I don’t think that central banks will continue to raise rates throughout this year. The inflationary curve will turn this year. Yes, the central banks did get their assessment wrong, and fed is perhaps sitting on hundreds of billions of dollars worth of unrealised losses, I do believe that the economy won’t run away from the central banks. Going forward, I do feel that central banks will gain a better control of the economic levers.

Economic growth has already slowed significantly and so has the demand. Companies are firing employees and cutting down on expenses to better prepare for a slowing economy. The supply chain and logistics are looking better. It is getting much easier to find containers to ship goods, and the freight costs have also come down. Banks have tighten their lending. And all the significant economic data is showing a definite slowdown in the economy. My senses tell me that inflation is close to reaching an economic Karman line. Earth’s gravity, in this case, the economic slowdown, will bring the inflation down. Economic indicators will eventually start capturing these data from the real economy. Reporting is always delayed, and inflation may go higher in July and August, but based on what I see, the trajectory of inflation is changing already.

According to national bureau of statistics, China. Prices of fresh vegetables, eggs, fresh fruit and seafood dropped due to factors such as increased supply and improved logistics. Businesses are adjusting to the new economic reality, and perhaps a recession is what the economy needs to adjust.

It will be a good thing for the overall economy. Some businesses will fail, and that’s natural. There are a lot of zombie companies out there created by a low interest environment that some might say lasted for too long causing large scale misalignment in the economy, and money managers will have to adjust on how they allocate capital going forward. Rising rates might also help improve bank’s traditional business model. In the current environment cash genuinely becomes the king, and more and more investors will continue to hold investments in cash.

If I was a central bank then I would surely refrain from raising rates further, and rather focus my efforts on inducing a very well managed recession, which is the need of the hour. Raising rates aggressively to cool inflation will cause long term damage to the economy especially because the energy price information is a direct consequences of the ongoing war in Ukraine, and relying on rate hikes alone to control energy private induced inflation isn’t really a prudent policy step. So the central banks will need to redirect their policy measures on inducing a well managed recession in the economy. That is how you guarantee a soft landing without running the risk of breaking the economy.