Do we need a recession to dampen inflation?

The question is beginning to haunt markets: will it take a recession to quell inflation? And would a recession even be a good way to eliminate unwanted inflationary phenomena such as speculation?

Posted at 6:30am

Extremely rare are economists who want a recession or envisage it as a solution. Because this hated word that starts with R would lead to dramatic consequences that can lead to social unrest: layoffs, bankruptcies, debts, house seizures, etc.

But the question is: will central bank rate hikes to curb inflation be enough to slow the economy without pushing it into recession?1 ? And if so, would a recession cleanse the economy like a bursting abscess?

Since March 2, the Bank of Canada has raised interest rates by 0.75 basis points and is now at 1%. A further increase of 0.5 points to 1.5% is expected for June. The influential American central bank (Federal Reserve) will follow the same rhythm and would have the same course in June.

Economists then expect a key interest rate of around 2% to 3% at the end of 2022. Such an increase will inevitably have repercussions on the range of short-term interest rates and thus, for example, on certain mortgage rates.

Need we remind you that an increase in interest rates encourages consumers to invest their money rather than spend it, thus dampening demand for goods and services and hence inflation?

The federal funds rate would remain historically low at 3%, but some believe that at this level it could trigger a recession.

Why is that ? This is because short-term interest rates could then be higher than long-term ones. And that such an inversion of the yield curve, a sign of lack of confidence in the future, is a harbinger of a recession.

In the last 60 years, there have been 10 occasions when interest rates on 3-month Treasury bills have risen above 10-year rates in the United States. And in 9 out of 10 cases, such a situation has led to a recession, notes the National Bank’s chief economist, Stéfane Marion.

This interest rate for 3-month Treasury bills in Canada, which is heavily influenced by the Bank of Canada’s key interest rate, is currently 1.3%. With the current price development, it could therefore rise to around 3% by the end of 2022 and end up at the level of 10-year bonds.

That 10-year rate, which is fairly independent of the Bank of Canada’s benchmark rate, currently stands at 2.87% and shouldn’t rise much further, according to economists. In short, an inversion in the face of the yield curve heralding a possible spring 2023 recession.

However, Stéfane Marion believes that the central banks will act cautiously. A more moderate rate hike will slow the economy and be enough to curb inflation, he believes. “No need for a recession,” says the economist, predicting a soft landing.

Economist Maurice Marchon believes a recession fueled by interest rate hikes would partially solve the problems of inflation, “but that we must not go that far,” says HEC Montreal professor emeritus.

Nevertheless, the forecaster does not rule out a recession within a year, particularly in Europe and the USA. “We’ll be fixed by the end of 2022,” he said, judging that Canada and Quebec, however, were less affected by the war and the oil shock.

Not just a question of tariffs

So a simple slowdown to dampen inflation? And a reasonable rate hike? The problem is that inflation isn’t just being caused by strong demand from consumers and businesses with good pockets. It is also the result of supply shocks, explain Stéfane Marion and Maurice Marchon.

Sébastien Lavoie, chief economist at Laurentian Bank, estimates that around half of inflation is due to strong demand and the other half to a supply shock. This shock is explained on the one hand by the explosion in oil prices and on the other hand by the restrictions imposed on the global supply chain. The war in Ukraine and COVID-19 – which continues to disrupt Chinese production – are responsible for this supply shock.

Added to this, particularly in Quebec, is the aging of the population, which is exacerbating labor shortages and putting downward pressure on wages.

Fewer and fewer economists believe that inflation is a temporary phenomenon after the pandemic. On the other hand, inflation will return to a more moderate range within three to five years.

According to Maurice Marchon, everything will depend on the reaction of the labor market.

The problem is exacerbated when inflationary pressures are transmitted directly to wage demands, which then affect the prices of goods and services in an upward spiral that is difficult to stem.

Especially on site we see that the employees want their salaries to keep up. We’ve seen it in the recent deals with food company Olymel, as in the recent rejection by Bombardier employees of an offer deemed insufficiently generous.

According to the President of the Conseil du patronat du Québec, Karl Blackburn, the economy has spiraled into a veritable inflationary spiral.

“It’s the perfect storm for employers. There will be closures in certain sectors like restaurants, tourism and retail as businesses will not be able to pass on cost increases to customers,” he says.

A positive sign, however, is that trade union and employer parties are negotiating in the new collective agreements on wage increases that are not fixed in the medium term and are therefore inflation-promoting.

Rather, it is a question of agreement, where the amount of the increase is based on possible inflation, explains the President of the CSN, Caroline Senneville. For example, in the third year there is not a 5% increase, but an increase according to the consumer price index, plus a small margin.

“The word ‘inflation’ will be very present in the negotiations, especially as price increases affect basic necessities such as housing, food and transport,” she Senneville.

Undoubtedly, the economic situation is complex and very delicate.

1. A recession is defined as a decline in gross domestic product for two consecutive quarters.

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