How Can Inflation Be Under Control Without a Recession?

How can inflation be considered slain even as the government strenuously denies were in a recession?

They went so far as to change the definition of the word recession.

And now the Fed is saying it can keep rates neutral. The market thinks inflation is finished. 

But how can that even be possible if we’re supposedly not in a recession, and in fact just the opposite—the economy is roaring! Best it’s ever been!

The government keeps pointing to job gains and away from contracting GDP as evidence we’re not in recession. But how then can inflation be tamed if the labor market is still expanding? If people are still landing jobs and getting pay raises?

That means the “wage” part of the Wage-Price Spiral is still going up, and thus prices will keep going up—thus inflation persists. 

So on one hand you have the government saying there’s no recession in sight, in fact there’s no such thing as a recession at all! It’s a myth. They don’t exist. We have evolved beyond the need for recessions.

On the other hand you have the market believing inflation has been stopped cold in its tracks. 

This is not possible. The only way we’ll see inflation come down is if and when we go into a recession, and people start losing their jobs, and they can’t afford to pay these higher prices.

In other words, demand has to fall for inflation to subside. Demand has to be destroyed.

The government is clearly telling us that hasn’t happened and that the economy is booming like it’s 1984 again.

Yet somehow we’re to believe inflation has been slain without a recession at all? It’s just not possible. Not when 40% of all dollars in circulation were printed in the past 2 years.

It feels like the prevailing market wisdom right now is little more than a fairy tale: the Fed hiked to 2.5%, inflation was arrested, and there was no recession at all!

Wow! How incredible! Perfectly executed. What are the odds?

I hate to break it to people but inflation will persist until we are deep in recession.

Recession is the cure to inflation.

Inflation is not some mystical force that the Fed can cast a spell and banish from the land—it’s simply rising prices. A Big Mac that costs $9.49 when it used to cost $7.49. That’s all.

The only way rising prices come down is if there’s no demand at those higher prices. Say McDonald’s jacks the price of a Big Mac up to $36 and people stop buying them all the sudden—demand dries up. Well pretty quickly the price will come down in order to meet consumers at an acceptable level. Companies—for the most part—can only charge what people can afford for goods and services.

Toyota can’t just say, “The Corolla now costs $250,000.” Nobody would buy it. Certainly there are people out there in the world who can afford a $250,000 car, but they’re not interested in a Toyota Corolla. They’re buying Bentleys and Ferraris.

The typical Toyota Corolla buyer can’t afford to pay $250,000 for one. If Toyota doesn’t bring that price down, they’ll never sell a single Corolla.

Similarly, there are people out there who can afford to pay $36 for a burger, but they’re not doing so at McDonald’s. The typical McDonald’s customer does not have the ability to pay $36 for a hamburger. If McDonald’s doesn’t cut their prices, they’re going out of business.

This is what I mean when I say companies can only charge what their customers can afford. Obviously there are exceptions, like monopolies who know you have no other options and have to pay whatever they charge, but that’s beyond the scope of this example I’m making. 

In general, companies have to lower their prices if no one is buying or else they go out of business. It’s all about supply and demand. This is how prices come down in the housing market, too

And so the cure to inflation is for people to stop paying these high prices, forcing retailers to cut prices. The only way this happens is if people suddenly start losing their jobs and their incomes. Job losses = demand destruction = falling prices.

Now another variable here is the supply chain: why are companies charging higher prices in the first place? The reason is because it’s more expensive to produce things. Say the ingredients for a Big Mac used to cost a total of $5 overall. Now they cost $10 because there’s a shortage of, just for example, thousand island dressing. The price of thousand island dressing has been soaring to the moon! Now it costs McDonald’s $10 to assemble one Big Mac, which means it costs you $12 to buy that Big Mac when it used to cost $7 not even two years ago.

Anywhere along the chain—from the cow on the farm to the restaurant—that the price increases on any component or ingredient in a Big Mac, you will see higher prices. That could even be labor: say the government doubles the minimum wage. The guy flipping your burger is now making double. That’s going to be reflected in the cost of your burger. McDonald’s is going to pass that higher labor price on to you. After all, they’re not going to last very long selling burgers at a loss are they?

This is that dreaded wage-price spiral. The workers demand raises due to rising costs of living, so in order to be able to pay their employees more, companies hike prices. This means consumers are getting squeezed once again because everything is more expensive. Which leads to them demanding raises again, which in turn employers can only pay for by hiking prices yet again, which raises the overall cost of living and necessitates even higher wages.

Somewhere in that chain, the relationship must be broken. Generally it’s the wage part that has to be broken before price increases can be arrested. Higher interest rates make everything more expensive for companies, and the single largest expense is labor, so job cuts are the number one way to reduce expenses. Job cuts mean a weaker consumer, and no more ability to pay higher prices. So prices have to come down to meet consumers where they are (i.e. poorer).

This is what I mean when I say the cure to inflation is recession. How can inflation be tamed if we’re not in recession? It’s ridiculous.

The federal reserve has not hiked rates any where near enough to arrest inflation. In all likelihood, we will go into recession first, and inflation will be persistent—in other words, we’ll have stagflation. Inflation will persist even as the economy is contracting.

Inflation will not be stopped until the recession gets really bad–when houses go bidless because people can’t afford to move. In all likelihood a very mild recession will not tame the inflation we’re seeing right now.

I personally believe we’re in the beginning stages of this recession. (Actually, I think we’ve been in recession since March 2020, but the government masked it with stimulus and low interest rates and money printing. But that’s just me.)

But if we’re in the beginning stages of a recession, it means we still have a ways to go before we actually bottom out and can start recovering. It’s not as if prices cease rising the second we enter recession.

In the late 1970s and early 1980s, Fed chairman Paul Volcker simply hiked interest rates until inflation started to come down. Eventually he got rates up over 15%. His policy was simply, whatever it takes. It was a devastating recession for most Americans, but it stopped the inflation. Eventually.

In the Volcker era, he hiked until interest rates were above the official inflation rate. This meant, again, bringing rates up above 15%. That’s what it took back then. 

Nowadays we think 2.5% interest rates will stop 9.1% inflation? Explain that one to me.

Inflation compels people to spend instead of save, right? Because if my money is losing value sitting in my bank account, and I’m only earning like 0.1% interest on it, then I should probably spend it instead of losing 9% of it to inflation (this of course contributes to inflation, this impulse to spend rather than save.)

Interest rates must be higher than the rate of inflation to compel people to save rather than spend. It’s very simple. When interest rates are above the inflation rate, it’s smart to save because you’re making money on interest. Buy when inflation is above the interest rate, you’re actually losing money by saving money. 

Bill Ackman explains this on twitter:

“On Wed, Powell said that the @federalreserve had gotten rates to neutral: “We’re at 2.25 to 2.5% and that’s right in the range of what we think is neutral.” The bond and stock market have rallied substantially since, as the implication is that rates need not increase much more.

The problem is that we are not close to a neutral rate. While 2.25 to 2.5% may be a neutral rate with 2% inflation, it is an extremely accommodative rate with inflation at 9%. One’s cost of borrowing is a function of the interest rate and the rate of inflation during the term of the loan. Inflation reduces the cost of borrowing as it is the ‘real’ interest rate that matters. The money in your savings account is decreasing by about 1% per month due to inflation so you are incentivized to spend it and borrow more. 

While businesses and consumers don’t borrow at the 2.25-2.5% FF rate, they pay a spread. But even at today’s credit spreads, the real cost of money is still extremely cheap so everyone is incentivized to borrow and spend, fueling inflation. That is why in previous highly inflationary economies, the Fed had to raise rates above prevailing levels of inflation to kill it. 

While I do think inflation will begin to come down soon, I don’t think there is any prospect of getting back to 2% without materially higher rates, 4% or more, which are maintained at these levels for extended periods. I am puzzled to understand how the Fed believes that we are already at neutral. It is counter to everything I understand about basic economics. A neutral rate of 2.25-2.5% only makes sense in a world with 2% stable inflation. It makes no sense in a world with 9%, 6% or even 4% inflation. Powell’s views on the neutral rate have only served to materially ease financial conditions making the inflation problem worse and his job more difficult. The Fed should clarify how it has determined that we are indeed at neutral. Greater clarity would be helpful for all.”

Obviously Jerome Powell isn’t stupid.

He knows he’s not at a neutral rate. It’s possible Ackman misunderstands what Powell means by “neutral rate.” In my last post I quoted Alf from Twitter who describes the neutral rate as the area for the fed funds rate where the Fed is neither contributing to inflation nor causing recession. Thus the Fed will now become data dependent in order to see if inflation comes down naturally now that the Fed is no longer contributing to it. 

Powell thinks any fed funds rate below 2.5% is contributing to inflation. Now that he’s at 2.5%, he should expect to see inflation come down. Not all the way, but somewhat, as the Fed is no longer contributing to it, he believes. 

The obvious problem here is that the cat is already out of the bag. The wage-price spiral has already begun. Companies are hiking wages to entice workers in an effort to fill the gap caused by the “Great Resignation.” The Fed is still behind the curve.

Powell knows that 2.5% interest rates will not tame 9.1% inflation. Yet he’s talking like inflation is more or less vanquished.

This goes back to what I’ve been saying the whole time: the Fed’s main goal right now is to simply prevent mass financial panic as they execute their controlled demolition of the economy.

They keep giving the market hope by speaking optimistically. They don’t want people bailing on the stock market en masse and causing a massive, 2008-style collapse.

They want an orderly deflation of the asset bubble, not a crash.

But make no mistake about it: they are panicking. They hiked rates by 75 basis points twice in a row. That has not been done for a very long time. We are in a tightening cycle of unprecedented speed and urgency.

Don’t be fooled here.

Update: at 4:30pm on a Friday, conveniently after the market was closed, the New York Times published an interview with Minneapolis Fed President Need Kashkari. It carried this headline:

So he completely undercut the entire rationale for this week’s furious stock market rally.

Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, suggested on Friday that markets had gotten ahead of themselves in anticipating that the central bank — which has been raising interest rates swiftly this year — would soon begin to back off.

“I’m surprised by markets’ interpretation,” Mr. Kashkari said in an interview. “The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that.”

Fed officials raised interest rates by three-quarters of a percentage point this week, their second consecutive supersize rate increase and a move that took their policy setting to a range of 2.25 to 2.5 percent. That’s roughly what policymakers think of as a neutral setting, one that neither stokes nor slows growth, and further increases in interest rates will begin to actively hit the brakes on the economy.

Given that fact, Jerome H. Powell, the Fed chair, said policymakers would now set rates meeting by meeting rather than committing to a broad plan well in advance. Investors took that as a sign that the central bank was likely to slow rate moves sharply in the coming months as the economy slows. In fact, bond market pricing suggests that investors think officials may even begin to cut interest rates next year.

“I don’t know what the bond market is looking at in reaching that conclusion,” Mr. Kashkari said, adding that the bar would be “very, very high” to lower rates.


So the market screamed higher this week based on… a misinterpretation. That’s basically what Kashkari is saying here.

If you bought this rally you are likely going to get rugged very soon here.

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