What Is the Difference Between Inflation and a Recession?

“The outlook is uncertain again amid financial sector turmoil, high inflation, ongoing effects of Russia’s invasion of Ukraine, and three years of COVID.”

These are the opening lines of IMF’s recent World Economic Outlook. This is just one of the many mentions of high inflation and economic slowdown that concerns economies all over the world. From newspaper headlines to monetary policy statements, two economic terms—inflation and recession—have clearly hogged all the attention. Here’s a look at what these two terms mean.

What is inflation? 

Inflation is the rate of increase in prices over a given period, and thus, some inflation is considered healthy and associated with economic growth. However, if not handled well, inflation can plunge nations into periods of instability and chaos. In the past, hyperinflation has happened in Venezuela and Zimbabwe, while Japan has been in deflation since the mid-1990s, which has been a “significant fetter” of the economy. So, when it comes to managing inflation, extremes are considered bad.

Over the recent years, the U.S. and other major economies in the West have maintained a comfort level with 2% inflation. A note by the Federal Reserve in 2022 suggested that “the U.S. fiscal stimulus during the pandemic contributed to an increase in inflation of about 2.5 percentage points.” The policy action coupled with energy crisis emerging from the Russia-Ukraine war complicated things. In the U.S., inflation surged to a four-decade high of 9.1% in mid-2022. To combat the mismatch between demand and supply, the Federal Reserve has been using its monetary policy tools to “restore price stability by bringing demand into line with still-constrained supply.”

Over the past year, Fed has raised the federal funds rate by nearly 5%. Not just the U.S., according to an OECD report, in all countries, “both supply and demand factors are found to have pushed inflation up since mid-2020, highlighting the current difficulties faced by policymakers in assessing the drivers of higher inflation.” According to the data released on April 12, 2023, the consumer price index (all items) increased 5% for the 12 months ending March, making it the smallest 12-month increase since the period ending May 2021. While inflation has started to abate, the level of inflation which is acceptable to the Fed is still distant.

What is a recession?

Any economic cycle involves different phases, recession being one of them. Recession depicts low or dull economic activity. While there is no ‘official’ definition of recession, consensus is that if a country faces two consecutive quarters of decline in a real (inflation adjusted) gross domestic product, it is said to be in recession. While the U.S. did witness two negative quarters in 2022 (Q1 and Q2), it did not agree to be facing recession as it did not fit the criteria by the National Bureau of Economic Research (NBER). The NBER defines a recession as a period when there is “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” The NBER includes other variables to measure economic activity, such as real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes and industrial production. While the NBER does not account inflation directly in its methodology, it is embedded in real income and spending, which are crucial inputs.

Since 1858, the U.S. has seen 35 recessions and the causes have been different from one another. “Pessimistic consumers, the debt accumulations of the 1980s, the jump in oil prices after Iraq invaded Kuwait, a credit crunch induced by overzealous banking regulators, and attempts by the Federal Reserve to lower the rate of inflation have all been cited as causes of the recession” in 1990-91 by the Federal Reserve Bank of San Francisco. Meanwhile, the recession which began in December 2007 had its roots in the housing markets, which soon engulfed the global financial markets. The recession lasted till the mid of 2009, which made it the longest recession since World War II. According to the NBER, the U.S. experienced its shortest recession on record from February to April 2020 due to a sharp drop in economic activity due to the pandemic. As per recent estimates, the IMF projects the U.S. economy to advance by 1.6% in 2023 and 1.1% in 2024.

The Correlation

Any extreme in inflation is considered a deterrent to economic growth. Globally, majority economists and central banks agree that low, steady and predictable inflation is good for an economy. For this reason, central banks usually announce their “target” inflation rate and work towards steering the actual inflation in the economy toward that target using policy rates as the primary tool. However, the process requires a fine balance and too much tightening in a short span starts to impact growth, to the extent of pushing the economy towards recession. Thus, inflation and the state of the economy are intertwined in a complex way.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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