Is inflation about to drop as recession takes hold?

The Bank of England: by raising interest rates central banks could push the economy into recession.

(Image credit: © Hollie Adams/Bloomberg via Getty Images)

published 5 July 2022

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Even if we end up in recession, a more inflationary world awaits us

So what are we talking about today?

It’s the same old story as always – are we heading for inflation or recession or both, and what might central banks do about it, and what does all of that mean for your money?

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We have just got to the point in this story where central banks had agreed that inflation was not transitory at all and that they needed to raise interest rates to stifle activity and thus slow inflation.

However, people are now very much worrying that with the cost of living rising and clearly squeezing consumers, central bankers have come to this view too late, and that all they will achieve by raising interest rates is to push the economy into recession.

So let’s have a look at how we got here and try to figure out what’s most likely. This is going to be part one in a short series, as I don’t think I can tackle all the variables in one article (well, not without you going to sleep by the end of it, at least).

The “staying in” versus the “going out” economy

We sometimes say that the pandemic shut the economy down in early 2020. But that’s not really accurate. What happened is that a large chunk of the economy was shut down as people were forced to stay in their homes. But people largely maintained or even improved their incomes due to furlough schemes, which meant that demand remained constant.

Sometimes this is described as a divide between goods and services. But that’s not that helpful. Watching Netflix is a service. But buying indoor exercise equipment from Amazon is a good.

So let’s split it into “going-out” businesses and “staying-in” businesses. Supply of the former was cut off. So the remaining demand went into the latter, which enjoyed a boom.

As a result, a couple of things happened. Companies in the “going-out” sector – pubs, restaurants, and the like – largely survived as going concerns due to government assistance. But there was no demand for their services. So they weren’t hiring or stocking up for an uncertain future.

Meanwhile, anyone who sold goods or services to people stuck in their houses – the “staying-in” sector – saw demand surge. Business for these companies boomed, and in many cases, they appear to have assumed that this demand would continue forever – or that at least some of it would stick permanently.

This assumption may seem irrational – or at least rather optimistic – but you have to remember that there are a lot of incentives for individual managers to extrapolate good growth into the distance. Everyone loves a boom and wants to take responsibility for it, whereas bad news is always something else’s fault.

One part of the economy over-ordered while the other under-ordered So what does that add up to? In the first instance, it adds up to one chunk of the economy – the bit that shutdown – effectively under-investing for the future, while the remaining half effectively over-invested for the future.

This has manifested itself in lots of different ways. One obvious example is at the big supermarkets in America. Walmart and Target are among the highest profile shops struggling with big inventory backlogs.

They’ve over-ordered for two reasons – when the economy shut down, supply chains became very unreliable and getting stuff to customers was harder. Better to over-order and meet soaring consumer demand.

But timing that sort of thing is tough. Once some semblance of normality started to return, demand dropped off (as consumers started to want “going-out” goods and services rather than “staying-in” ones), and the supply difficulties lessened, which meant that unsold stuff started to pile up.

Do remember that these companies are logistics experts – you have to be, you’re basically running a logistics business. So if they’re having problems, most companies are having similar issues.

This effect also accounts for big queues at airports this year. Too much demand meeting an industry which has been hammered by shutdowns for the best part of two years.

It also more than likely accounts for the odd employment picture we have today. We have the mystery of missing workers, which some have put down to early retirement (certainly a possibility) or migrant workers leaving the country (there’s truth to this though as it’s happening everywhere, arguably that should be a wash).

But the whole lagging impact of the shutdown makes some sense of this too. Take a simple example: pubs and restaurants shut down, but supermarkets and warehouses are hiring. Staff leave the restaurants and go to work at the supermarkets. Many find they like it better.

You go through a situation where “staying-in” sectors over-hire due to high volumes of business. “Going-out” businesses don’t hire at all. Then, just as the “staying-in” sector is starting to see a turn, the “going-out” sector is understaffed and desperate for more workers. So you get this lag.

If inflation is transitory and recession is already here, central banks may have to cut

Fundamentally, all of this is what lies behind the argument that inflation has been “transitory”. The pig is making its way through the python. It causes a lot of distortions and discomfort on its way through, but in the end, supply and demand get somewhere back to normal.

This implies that somewhere in the near future, we’re facing gluts of all the things we had shortages of (so graphics cards might get cheap, say, which is why Nvidia and Taiwan Semiconductor are down heavily in the last six months, say).

It also implies that the labour market may not remain as hot as it has been as the “staying-in” companies rein in their spending and expansion plans, and the consumer “glut” of savings is chewed up in expensive energy bills.

Which in turn implies that inflation might start to look less ugly, and that central banks might end up having to eat their words and flip around before the end of the year.

This is an outcome that markets appear to be pricing in rather quickly, with many arguing that a recession may already have begun.

So that’s the argument for inflation being “transitory”, and a recession being baked in. And it’s a pretty compelling argument. Is there a case against it – or at least, a different view? We’ll return to that tomorrow.

Meanwhile, Merryn and I discussed some of these points on the latest podcast – if you haven’t listened to it yet, have a listen here (we also chat about bitcoin if that’s your thing).

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.