What is worse: Inflation or Recession? Many have posed this question to me over the past several months, so I thought it constructive to review their respective attributes and provide context to the challenge facing the U.S. Central Bank/Federal Reserve. First, it is essential to understand that the Federal Reserve has a dual mandate of Price Stability and Maximum Employment. The problem with this dual mandate is that they are often in conflict, which is the case today. Additionally, things outside the Federal Reserve’s control make their goals more difficult to achieve, such as government fiscal spending, structural labor issues, and global supply chain challenges.
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While inflation is often used synonymously with price increases, those increases are the symptom of actual inflation, which is an increase in the money supply. Milton Freidman, the famous monetary economist, said it best when he defined inflation as “always and everywhere a monetary phenomenon.” In lay terms, if you increase the amount of money/dollars in circulation, you will see a corresponding increase in the price of available goods and services, assuming those goods and services remain constant. The most recent example of this phenomenon is our current struggle with inflation, primarily driven by the trillions of additional dollars created by the Federal Reserve and spent by the federal government in response to the Covid-19 pandemic. So why is inflation so destructive? First, it does not discriminate and affects everyone, particularly the poor. Additionally, if inflation is ignored, the resulting price swings in available goods and services can cause lasting and potentially irreversible damage to the economy.
The National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economic activity spread across the market, lasting more than a few months, normally visible in real Gross Domestic Product (GDP), real income, employment, industrial production, and wholesale-retail sales.” Recessions are a normal part of economic cycles and are productive because they allow for the creative destruction of misallocated capital. However, along with the good comes the bad in the human toll of a recession, i.e., job loss. As spending/demand slows, businesses typically need fewer workers to bring their goods and services to market and are forced to make the tough choice of layoffs.
The “Soft Landing”
The Federal Reserve, through increasing short-term rates and reducing the money supply, is currently trying to bring down inflation and avoid a painful recession/dramatic increase in job loss, aka “Soft Landing.”
Unfortunately, history is not on the side of the Federal Reserve in accomplishing its goal. Consumers and investors need to respect the uncertainty of our current environment and act accordingly. FOR INVESTORS, DO NOT make big bets either way in terms of being too aggressive or too conservative. Develop a plan you can believe in and stick to it. FOR CONSUMERS, DO NOT frivolously spend and certainly do not accumulate variable rate debt you cannot quickly pay off. Be sure to consult a certified financial planner before you adjust your investments during this uncertain time.
Marshall Clay CFP, J.D., is a Partner and Senior Advisor at The Welch Group, LLC, specializing in providing Fee-Only investment management and financial advice to families throughout the United States. Marshall is a graduate of the United States Military Academy in West Point, New York, the Cumberland School of Law in Birmingham, Alabama, and is a CERTIFIED FINANCIAL PLANNER™. In addition, Marshall is a frequent guest on local television stations as an expert on various financial planning matters.
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