Why We Need A Recession
Central banks must to bring inflation down at all cost
With inflation soaring, many of us are struggling to pay our bills and the only remedy central banks can put forward is to raise interest rates, even though it will very likely trigger an economic recession.
Given that a recession makes a country poorer and means increased unemployment, how can it be a good thing?
Let’s see why central banks are probably right and we need a recession.
Inflation Remains High
Inflation kills both our purchasing power and our savings, and it is not showing any signs of coming down by itself.
If you want to know more about inflation and how it impacts our finances see our post:
Inflation has risen sharply in 2021 due to worldwide supply chain disruptions in combination with the money-printing policy taken by many countries.
During the COVID lockdown, for the first time, we voluntarily stopped the economy for a considerable time. We stopped manufacturing products, we stopped shipping them, and we stopped producing and consuming them in general. When the world opened up and the demand for those products we stopped producing rose again, they were not available (nobody produced them during the lockdown).
Demand and supply got out of whack. Products that were easily available in the market before the pandemic became scarce because production and transportation stopped for a long while. Since fewer products were available compared to pre-pandemic levels, people needed to pay more for them (they are more scarce). That, along with all the money-printing policies taken by governments, is why we have inflation everywhere.
Why Inflation Might Get Entrenched
The problem with high inflation is not only that damages the economy and people’s finances, the bigger problem is that it might get embedded in the economy. And that would be really bad.
If nothing is done to bring inflation down, trade unions will demand companies increase employees' wages so they match inflation, which is good. However, companies would then raise prices so they don’t become less profitable, which would keep prices increasing and unions claiming more salary raises. This back and forth would make inflation stay permanently in the economy.
Therefore, central banks must act to bring inflation down immediately. There is no way around it. Full stop.
What Central Banks Can Do
Since the world is not currently able to meet the demand for many products (supply is too low due to the stop in production and all the shipping bottlenecks generated by the pandemic), central banks have the option to reduce demand. In theory, by reducing demand the current supply would be able to cover it, solving the problem.
To do so, central banks can raise interest rates (the rate at which people borrow money). By making it harder to borrow money, fewer people will have access to money to purchase products and services and demand will go down.
However, raising interest rates also has other consequences, such as a diminishing wealth phenomenon. When interest rates rise, stocks fall (the future cash flows of a company are worth less when interest rates are high) and usually, house prices fall as well. That is because when people feel poorer, they are less willing to buy a house, purchase a particular product or consume in general.
Consequences On The Unemployment Rate
Another consequence of raising interest rates is the spike in the unemployment rate. When demand falls, fewer products are offered in the market, therefore, fewer people are needed to produce the products needed. Jobs get cut, and with fewer people working consumption decreases too.
Even though we are on the verge of a recession, the unemployment rate is currently low in the major economies.
Unemployment rate in the US: 3.7%
Unemployment rate in the UK: 3.8%
Unemployment rate in Germany: 5.5%
This gets to show that companies are not currently reducing the number of employees, but it will inevitably happen when demand decreases.
When central banks raise interest rates to lower demand, fewer employees are needed to produce goods. Therefore, a rise in interest rates is usually followed by an increase in the unemployment rate. And that is one main driver of an economic recession.
Conclusion
Central banks must act promptly to bring down the high inflation seen worldwide produced by a combination of supply chain disruption and the money-printing policy taken by many countries.
The only way central banks can do something about it is to raise interest rates.
A rise in interest rates will lower demand and increase the unemployment rate as a result.
This scenario will bring an economic recession in the US, UK & Europe.
Even though central banks must now take actions that will trigger a recession, it might be the only way we can avoid this high inflation to get embedded in the economy. We need an economic recession.