Recession Ahead: Necessary or Not?

Chairman of the Fed Jerome Powell has transitioned from calling inflation "transitory" to no longer transitory. Both positions were accurate at their respective times. This inflation is not driven by an excess of demand, but by COVID-related supply chain issues. It was logical that as COVID receded supply chains would open up effectively, but that has not occurred due to three factors: 1) chip shortages require longer start up periods, 2) the Chinese reverted to COVID policies in light of their zero tolerance policy and 3) the Russian invasion of the Ukraine. So inflation will last for sometime, but is not driven by an excess of consumer demand. Given that the Fed understands this, why would the Fed push ahead aggressively with rate increases? In a word - expectations.

The Fed is responding to concerns that a temporary set of supply chain issues becomes a permanent mindset for producers and consumers. The Fed always uses a blunt instrument. In 1999, the Fed could have used stock market specific tools to deal with the Internet Bubble, but chose instead to raise rates which punished the entire economy. Today, the Fed looks to apply the same punishment to slow the entire economy down to the speed of the supply chain's average production ability. This will certainly create a drop in demand by creating a drop in employment. However, that will quickly lead to a recession while not necessarily fading inflation until these three aforementioned factors abate. Ironically, if the Fed were to not act at all, the economy may more quickly resolve these issues with funding for increased production but at the risk of inflation expectations hardening.