Inflation vs recession: Could the Fed cause a recession?

What happens in the US doesn’t always stay in the US. In fact, economic and financial events that unfold across the Atlantic can often be reliable – but not certain – projections of what will happen in the UK and other nations.

There is currently some concern that the Federal Reserve, the US’s central banking system, could cause a recession. This is due to the Federal Reserve estimating six more interest rate hikes in 2022 alone. Could the Bank of England follow suit and cause the same in the UK?

To understand the potential of this and how it might play out, we need a crash course on the relationship between base rates, inflation and recessions.

Base rates, inflation and the possibility of a recession

Interest rates are increased or decreased by central banks to encourage people to spend less or spend more, respectively. When interest rates are higher, we are more likely to put money in a savings account than buy a house with a loan that we have to pay interest on – and vice versa.

Inflation is the general increase in prices over time. It always exists to some degree and central banks usually aim to keep inflation around 2%. When it goes above this level, it becomes a problem, which is the current situation around the world. Many factors contribute to the rate of inflation, including political events, war and natural disasters. But the base rate can also have some effect on inflation.

When the base rate is high it can cause inflation to decrease. This is because an increased base rate encourages us to not spend – demand goes down and supply goes up. And when supply is higher than the demand, businesses are required to decrease product and services fees to make sales. By decreasing prices, it mitigates or decreases the rate of inflation.

At the same time, if we are spending less of our money GDP will decrease. This is the market value of goods and services sold within a specific period. If GDP decreases for two consecutive quarters, then we have officially entered into a recession.

Thus, there is a link between increasing interest rates and causing a recession, which is why there is concern that the Federal Reserve’s projected six further increases in 2022 could cause a recession.

A complex situation

Despite the risk of recession, the Federal Reserve and other central banks have a difficult job on their hands, especially when contributing factors are being played out on a daily basis.

The Russian invasion of Ukraine is causing supply issues between Ukraine, Russia and the rest of the world. And China has announced new COVID lockdowns, causing many businesses to temporarily close. They have a difficult task trying to balance the risks of inflation and a recession when making their moves.

April 2022