Making Sense - Inflation and Recession
Updated: Aug 14, 2022
There is a lot of noise out there. And it is creating an overload of stress. Intent of this blog is not to add to the noise. Rather, I am hoping that this will help provide some clarity and perspective.
Two most common terms that are media favorites right now are inflation and recession. We all are feeling the heat of inflation, and the specter of recession is very uncomforting. Let us focus on these two today.
Last year, the Fed was of the opinion that as a covid fallout, we will see inflation but it would be transitory. Now with the inflation raging historically high and not looking to be at all transitory, the Fed has been ridiculed a lot on its “transitory” prediction. I am not defending the Fed. But the fact is that any stand we take is dependent on the data and the facts we have at that moment. Last year, the Fed knew that the supply chains were broken and consumer demand was distorted due to covid, so it was predicting inflation. And the logic was that once covid recedes, the supply chains would be reestablished and inflation would come down. The Fed does not have a crystal ball to look into the future and predict the attack on Ukraine, or the strict covid policies of China.
By nature, most inflations are demand driven. What this means is that when there is too much demand for fewer resources, prices of the goods go up and creates inflation. However, the inflation that we are seeing today is mainly due to supply constraints. Global supply of gas and food resources like wheat has been severely impacted by the Russian invasion of Ukraine. Simultaneously, there is a disruption of raw materials, parts, and goods from China due to its covid policies. These two are strong forces on top of the already broken supply-chains from the pandemic.
Question is how will this end? Let us hope that the war between Russia and Ukraine will end soon and world will return to some sense of normalcy. But what if it does not? What if the war drags on, with no one winning and everyone losing? I believe that in this case, new geopolitical alliances would emerge – democratic countries in one group, and the more autocratic countries in the other. Trading will be reestablished but would then be constrained more within each group. A divided world is not a scenario that any one of us would like to see. But a broken global supply-chain system for an extended period is hard to visualize. We human beings are creative and innovative and we find solutions – good or bad, to unexpected events. So, eventually the supply chains would be restored and this would help bring the inflation down. Depending on how things go from here, both on Ukraine and on covid, we can expect inflation for some time. However, in the long run, inflation should come down in the US. A very important factor for this is our aging demography. We are an aging nation and unless there are legal/immigration changes made to promote younger population, our demand would skew more towards goods and services for an older population. Economic growth flourishes with a younger population. It is the younger people who consume and spend and innovate. If our younger generation continues shrinking, we cannot expect the inflation to continue in the long run.
Given the current geopolitical situation and the economic data, it is not possible to predict how long the inflation would last. The Fed also seems to be of the same opinion. Last week, it raised interest rates by another 0.75 percent but did not give any guidance on future rate increases. Instead, it conveyed that its future decisions would be data driven. Based on what turns future events take, interest rates would be adjusted accordingly.
In addition to the inflation worries, last Thursday there was another drop in the Gross Domestic Product (GDP). This is the second consecutive drop in GDP and most people interpret this as a sign of recession. A recession is actually declared by National Bureau of Economic Research (NBER). NBER considers more factors than two consecutive quarters of negative GDP. Among other factors, it looks at labor market and industrial output. Both of these are still strong and therefore it does not look we are in a recession. These factors can deteriorate going forward, and a potential downturn is possible. However, the consumers in the US are financially more stable and hence a 2008 style recession is not anticipated.
This is all quite confusing and scary, so it is all the more important to remember to focus on what we can control.
Lavina Nagar, CFP(R) is the president and founder of Maya Advisors, Inc., a financial planning and investment firm in Palo Alto, California.