Inflation or recession? The challenge of the Central Banks

From the Federal Reserve in the United States to the ECB in Europe, which must "handle" monetary policy with care, that is, wisely implement interest rate hikes, which have been pinned near zero for many years on both sides of the Atlantic.

Today, as those who follow the daily news know, the major industrialized countries are in fact experiencing a wave of inflation, the likes of which has not been seen in 30 years. Both across and on this side of the Atlantic, the rise in consumer prices has exceeded 8-9 percent, seriously jeopardizing the purchasing power of consumers and workers. Both the Fed and the ECB, in order to curb the inflationary wave, have already started raising interest rates, since monetary policy is the most powerful weapon they have at their disposal against high prices.

Raising rates, broadly speaking, reduces the in fact amount of money in circulation and, consequently, also the boost to consumption and prices. However, there is no missing the other side of the coin. By depressing consumption and investment, raising rates is also a brake on economic growth. In other words, if the cost of money is raised too much or too fast, GDP is likely to go into recession, that is, below zero.

So what to expect in the coming months? First, a premise: the upward push in prices is a phenomenon that began as early as last year with the end of the Covid -19 pandemic. In fact, the recovery of economic activities generated strong demand for goods and services, which was not adequately met by supply. And as is always the case in such situations, prices received an upward push.

Then the war broke out in Ukraine, resulting in a shortage of raw materials, not only the gas exported from Moscow but also agricultural commodities produced in Ukraine. Dante Roscini, professor at Harvard Business School, however, urges us to look at what is happening in Europe and the United States with different optics. "While the U.S. is now energy independent, Europe is still dependent on Russian gas," Roscini explains.

So, the scarcity of gas and the high price levels of this energy commodity are a boost for the carovita in the Old Continent. Therefore, as already announced, the ECB will have to give further tightening the cost of money, raising interest rates again to stop inflation, taking advantage of the fact that unemployment in Europe is at its lowest. Thus, there is room for maneuver so that a slowdown in the economy, resulting from the carotaxis, will not have too severe an effect from an employment perspective.

That being said, Roscini points out that the prospect of a recession in Europe in 2023 is therefore to be considered likely, although monetary policy authorities will obviously have to weigh all the costs and benefits in the balance, primarily the risk of a fragmentation of the euro area, as has happened in times of crisis in the past.

The situation is different in the United States where, on closer inspection, there have already been two quarters with negative GDP and where interest rates have been raised by the Federal Reserve faster than on the other side of the ocean.

In the U.S., Roscini points out, there are mixed signals today. Some indicators suggest that the peak of inflation has already been reached and that therefore the central bank may be softer than expected in its policy of raising the cost of money: the price of gasoline has fallen sharply in recent months, as has the cost of housing, while the level of inventories is at a 20-year record. In addition, the strong dollar may have deflationary effects because it decreases the cost of imported goods.

At the same time, there are other indicators that suggest otherwise: unemployment is indeed at its lowest and labor shortages are pushing up wages, which then have indirect effects on price growth. The cost of housing is also rising, and some analyses suggest that, after the effects of the IT revolution, it has peaked and is not likely to grow significantly in the coming years.

Usually, an increase in labor productivity decreases inflation because it makes goods and services affordable at a lower cost while a decrease in productivity has inflationary effects. Thus, the Federal Reserve, too, will have to weigh the costs and benefits of a rate hike on the scales. Currently, there is still room for the cost of money (now already above 3 percent) to rise further during 2023. However, precisely because of the mixed signals on inflation described above, it is not certain that the United States will experience a heavy slowdown in the economy will go through a recession within a year.

Also highly articulated is the situation in China, where there are factors pushing toward an economic slowdown after years of soaring growth.

One such factor is the policy of containing Covid-19, which always prompts authorities in Beijing to implement strict lockdowns as the Chinese vaccine has shown poor efficacy.

The second factor is the decline in house prices, which are now about 40 percent lower than the peak levels touched in years past. This is far from negligible considering that about two-thirds of Chinese households' wealth is in real estate assets.

However, there is no shortage of aspects pushing in the opposite direction. In China, President Xi Jinping's power appears as solid as ever ad his re-election in the next Communist Party congress is highly likely. Beyond the political aspects, for many analysts the strengthening of Xi Jinping's leadership should have positive effects on GDP, after recent slowdowns, due to a new expansionary economic policy by the government.