Inflation and recession: Can the world defeat both in 2023?

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When global leaders gathered at the annual World Economic Forum conclave in Davos last month, they were looking at a bleak economic scenario.

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Two-thirds of the economists polled by the WEF for its Chief Economists Outlook report said a global recession – a shrinking of the world’s gross domestic product – was likely in 2023. Also in January, the World Bank warned the global economy was “perilously close to falling into recession”.

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Since then, the International Monetary Fund in its end-January assessment has presented a less pessimistic forecast, suggesting that the global economy might avoid contraction this year. Still, the IMF has predicted that the United Kingdom’s economy will shrink and has cautioned that the United States has only a “narrow path” to escaping a recession.

The IMF, World Bank and many other experts have pointed to one key factor pushing the economy towards a recession: sharp interest rate hikes by central banks in recent months to tame soaring inflation.

So does the world need to choose between spiralling prices and a recession whose threat itself has sparked major layoffs, with more than 100,000 tech workers fired just in January? Amid economic crises, do people in effect need to choose between affordable fuel and a steady job? Al Jazeera posed these questions to leading economists.

The short answer: Curbing inflation is a painful exercise and, in most cases, leads to an economic slowdown. Yet it is a vital task for central banks because high prices affect the poor the most. The somewhat good news: Europe – a continent confronted with Russia’s brutal war and resulting energy shortages – might be showing how inflation can be tackled without tipping the economy into recession.

Decoding interest rates
The primary job of central banks is to achieve price stability. In fact, most central banks in developed countries target consumer price inflation near 2 percent – and they aim to keep prices in control by managing the amount of money and credit available in the economy.

The interest rate at which they lend to other banks is their most important tool. Low rates allow businesses and people to borrow more from banks. This, in turn, drives economic activities.

Amid the COVID-19 pandemic that crushed the global economy because of lockdowns and supply chain bottlenecks, central banks around the world cut interest rates to spur demand – an approach known as a loose monetary policy.

However, as economies opened up, consumer spending rose sharply, leading to decades-high levels of inflation. In response, central banks tightened their monetary policy and hiked interest rates to increase the cost of borrowing money.

Since early last year, the US Federal Reserve has increased the interest rates by 4.5 percentage points, with its latest hike on February 1. In the same period, the European Central Bank has hiked rates by 2.5 percentage points. In some countries like Brazil, the interest rate hike has been much sharper – by 11.75 percentage points since March 2021, and in Sri Lanka by 10 percentage points.

The idea is to lower consumer demand with the hope that people will postpone spending money to buy a car or go on a vacation.

“Using monetary policy to control inflation is a blunt tool,” Manuela Moschella, associate professor of international political economy at the Italy-based Scuola Normale Superiore, told Al Jazeera. “It ends up affecting everyone by increasing the cost of money for both households and businesses if the interest rates are hiked.”

The approach appears to be working in many countries, which are seeing inflation levels cool a bit. In the US, for instance, inflation has come down sharply from a four-decade high of 9.1 percent in June 2022 to 6.5 percent in December. In Brazil, consumer price inflation has eased from its peak of 12.1 percent last April to 5.8 percent in December.

However, increased interest rates have other consequences for the economy too.

Sonal Varma, managing director and chief economist for India and Asia (excluding Japan) for financial services group Nomura, said that as borrowing costs go up, companies slow down on investments or start reducing their workforce.

That, according to experts, is a bitter pill that economies – and the millions of workers driving them – often have no option but to swallow.

Breaking the inflation spiral
The economic logic of curbing inflation is simple, suggested Varma.

Higher prices force people to demand better wages, she said. While increased wages in themselves are a healthy sign, they also raise expenses for companies. “That will feed back into higher prices as firms will increase the cost of their goods and services,” Varma told Al Jazeera. “This will create a negative spiral.”

It’s a spiral that often hurts the poorest people the most, because they usually have low bargaining power when it comes to wage negotiations and lack sufficient savings to deal with the rising cost of living.

But as central banks increase interest rates to tamp down on demand, an economic slowdown – and in some cases, even recession – is a direct outcome. And economists expect central banks to continue hiking rates, at least in the near future.

“We will have to engage in more aggressive [monetary policy] tightening,” Willem H Buiter, a former member of the Monetary Policy Committee of the Bank of England and former chief economist at Citibank, told Al Jazeera. “And the result of that will be an economic slowdown everywhere, and depending on the country, this could take the form of a full-fledged or a mild recession.”

Radhika Pandey, a senior fellow at the New Delhi-based National Institute of Public Finance and Policy (NIPFP), agreed. Public comments made by the US Federal Reserve point to its plans to keep increasing the cost of borrowing until job vacancies go down or signs of an impending recession are clearer, she said. The latest data shows that job openings in the United States rose to a five-month high in December – a reflection of a strong labour market.

Meanwhile, “inflation is still at elevated levels”, Pandey said to Al Jazeera. According to the IMF, global inflation is expected to fall from 8.8 percent in 2022 to 6.6 percent in 2023, but it will still remain above the pre-pandemic levels of 3.5 percent.

Another way
Yet the IMF’s recent, hopeful suggestion that the global economy might grow in 2023 indicates that a recession isn’t an inevitable outcome of the fight against inflation.

To maintain price stability while avoiding recession, central banks need support from their countries’ governments through other policies, said Moschella of Scuola Normale Superiore. “The central banks’ monetary policy tools work best to address the demand problem. But the central banks cannot tackle the supply-side issues, for instance, the energy shock,” she said.

Europe’s already providing an example that appears to be working – the IMF referred to the continent’s “better-than-expected adaptation to the energy crisis” as a key reason why the world might avoid a recession.

Many countries in Europe have tried to subsidise high energy costs, put caps on electricity prices for vulnerable population groups or introduced tax incentives.

Take the case of France. It froze household gas prices at October 2021 levels and capped the electricity price increase in 2022 at 4 percent over the previous year.

For 2023, the power and electricity price increase is capped at 15 percent – with poorer households getting upfront cash transfers. Spain has followed similar policies.

To be sure, the global cost of living crisis has affected French and Spanish families too, and recent pension reform proposals by the government of French President Emmanuel Macron have sparked protests. But the measures to control energy prices meant that France and Spain had the lowest inflation rates among major Eurozone economies in 2022.

In all, the IMF has said that the “resilience” shown by Europe in terms of its economic performance is partly because of the government support to the tune of 1.2 percent of the European Union GDP to households and firms hit by the energy crisis. By November last year, EU countries had set aside 600 billion euros ($654bn today) for these measures.

By helping curb inflation, these measures have allowed the European Central Bank to raise interest rates less than other developed economies like the US. And Europe’s economy, which was expected to shrink in the last quarter of 2022, instead grew marginally by 0.1 percent.

Striking teachers show posters during a protest march in London, Wednesday, Feb. 1, 2023. Thousands of schools in the U.K. are closing some or all of their classrooms, train services will be paralyzed and delays are expected at airports Wednesday in what’s shaping up to be the biggest day of industrial action Britain has seen in more than a decade, as unions step up pressure on the government to demand better pay amid a cost-of-living crisis.(AP Photo/Alastair Grant)
Striking teachers show posters during a protest march in London, February 1, 2023, amid a cost-of-living crisis [Alastair Grant/AP Photo]
Too late?
But could central banks have responded differently? When inflation began rising after COVID-19 restrictions eased across countries, central banks initially estimated that the price rise would be temporary and transitory, said Buiter. “It turned out to be neither of those,” he said.

Some experts have said central banks were too slow in responding to inflation – caused by rising consumer demand, disruption of natural gas supplies from Russia, and other supply-chain challenges. Today, even Japan, a country that in Buiter’s words “had forgotten what inflation means” is witnessing its highest rates of inflation in more than four decades.

This isn’t the first time that central banks have faced such criticism.

“During the 1975 global recession, policies generally remained supportive of demand, even as inflation was elevated,” according to a September 2022 assessment of past recessions (PDF) by the World Bank. This “contributed to persistent inflation” for years, the policy note said. Eventually, advanced economies – especially the US – tightened monetary policy, bringing down inflation, but this was “also the main driver of the 1982 global recession,” according to the World Bank, which argued in the note for a “timely” response to inflation.

However, Moschella cautioned against blaming central banks entirely for their misjudgement of the inflation that has scarred families around the globe in recent months.

“Before the COVID-19 pandemic, in most advanced countries like the USA or Eurozone, we saw a decade of deflation when inflation was not picking up and they struggled to revive economic activities,” she said. “Inflation did look transitory in the beginning.” Now, as they play catch up, “central banks have to press the acceleration button really hard”, Moschella said.

Over the past half-century, the world economy has – apart from 1975 and 1982 – also seen recessions in 1991, 2009 and 2020.

Even if the world manages to avoid a recession in 2023, a sharp economic slowdown will hurt millions of working people globally, according to economists. Measures taken by European nations too will only soften the blow for their citizens, not shield them completely.

“Painless disinflation is a myth,” Buiter said.

SOURCE: AL JAZEERA

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Naija247news is an investigative news platform that tracks news on Nigerian Economy, Business, Politics, Financial and Africa and Global Economy.

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