Recession Is “Strong Medicine” of Global Inflation

The Federal Reserve, the central bank of the United States, increased its benchmark-interest rate on 15 June 2022. The Fed is trying to control US inflation, which amounted to 8.6 percent in May, the highest since 1994. Many people are worried that the interest-rate hike is an overdose that could drag the US into a deeper recession; the problem is the production side of the world economy that has been disrupted by the Russian-Ukrainian war.

The standard recipe in reducing inflation is to "recess" the economy by lowering the demand side. The trick is to reduce the expansion of the money supply and increase the central bank's benchmark-interest rate or other instruments that can tighten liquidity.

In this way, people -- both consumers and producers -- can reduce spending. However, the recession has its costs, namely increasing unemployment. It is necessary to find a strategy to minimize it (Okun, 1978).

The impression of a "strong medicine” can be seen from the large increase in the interest rate, which amounted to 75 basis points in July, because inflation in June had already increased to 9.1 percent.

With such an elevated inflation rate, the Fed insisted on the need to increase its benchmark-interest rate. The impression of a "strong medicine” can be seen from the large increase in the interest rate, which amounted to 75 basis points in July, because inflation in June had already increased to 9.1 percent.

There are several reasons for such an elevated interest rate. The first is the issue of credibility and reputation (Persson and Tablelini, 1994). The Fed wants to improve its image with a more aggressive (hawkish) response to inflation. The Fed has been considered too slow (behind the curve) in increasing its benchmark-interest rate after accommodative-monetary policy during the pandemic. With liquidity piling up in the community, the benchmark-interest rate should have been increased earlier.

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The second reason is the declining buying power of consumers. A recent survey conducted by CNBC examined the impact of inflation on the upper-middle class, who earn at least US$100,000 per year. The result of the survey showed the decline in the public demand. About 65 percent of respondents were concerned about elevated inflation, which led to the change in people’s spending behavior. As many as 77 percent reduced eating out, while 69 percent reduced entertainment spending and 63 percent reduced traveling expenses. In addition, 55 percent reduced household expenses for electronic devices and furniture and 45 percent would not buy a car.

If the upper-middle class changed their spending patterns, the burden of inflation on the minority group could be doubled (Torbecke, 2001). This pessimism and concern could turn recession expectations into reality because of the chain reaction of reduced public spending.

Recession outlook and global impact

A survey conducted by CNBC on a number of CEOs in the US in early May indicated that there would be a recession in mid-2023 with a probability of more than 50 percent. However, the prediction looks conservative because the impact of the Fed's rate hike has just begun to be felt. In the US, the prices of US stocks on Wall Street have also begun to fall. There are also early signs of the weakening of several indicators, such as home sales, consumer-confidence index and copper prices.

Technically, recession occurs when there are two consecutive quarters of negative growth. US growth drastically fell to 1.6 percent in the first quarter of 2022. The growth data for the second quarter, which will be released at the end of July, will also receive the world's attention. As the US is the global-economic locomotive, the impact of the Fed's interest-rate hike will have a spillover to the world economy through recession, expectations or other channels (Ahmed et al, 2021).

The global impact of the Fed's policies has been seen in international oil and commodity-futures markets. The global oil and commodity-futures prices are vulnerable to future expectations. Commodity-futures exchanges can affect the physical market that is determined by supply and demand. Since the increase in the US benchmark-interest rate, the price of WTI oil has fallen from $119 per barrel to between $100 and $96 per barrel within a month.

The policy of increasing the benchmark-interest rate, which was initially only intended to reduce domestic demand, turned out to have caused a decline in prices on global commodity-futures exchanges due to expectations of a recession.

The price of wheat had dropped from nearly $13 per bushel in mid-May to $8 in mid-July. Meanwhile, palm oil prices have fallen from about 7,000 ringgit (US$1,570) per ton to 3,900 ringgit per ton. For the US, the reduction in global inflationary pressures is a bonus. The policy of increasing the benchmark-interest rate, which was initially only intended to reduce domestic demand, turned out to have caused a decline in prices on global commodity-futures exchanges due to expectations of a recession. This affects the production side in the US and the world (Roldos, 1995).

Although global inflationary pressures have eased, for other countries, the problems do not end here. Due to the decline in the prices of a number of global commodities, investors in world futures-exchanges switched to safer financial assets, increasing capital flight to the US.

As a result, the US dollar index rose to almost 109, the highest in the last 20 years. Other currencies weakened. The euro, for example, depreciated past parity of 1 US dollar equal to 1 euro for the first time in two decades. As a result, inflationary pressure, which originally increased due to commodity prices, further increased due to imported inflation caused by currency depreciation. The European Central Bank (ECB) also plans to increase its benchmark-interest rate at the end of July and September.

The rupiah was also affected. It dropped from Rp 14,600 in early June to Rp. 15,000 in mid-July, before stabilizing at Rp 14,990 per US dollar. The inflation in June also increased to 4.35 percent, the highest in the last five years.

With the expectation of a stronger US dollar index, various options are available, including increasing the benchmark-interest rate to prevent import inflation and excessive capital outflows.

Every policy has its pluses and minuses. An increase in interest rates can indeed increase the cost of funds, but it is estimated that it will not affect the economy, which is still growing thanks to subsidies and an increase in people’s spending such as in trade, travel tourism and accommodation facilities.

One thing that must be watched out for is the rupiah depreciation, because it can lead to excessive inflation and the weakening of domestic demand. The good news is that the IMF predicts that the chance of a recession in Indonesia is quite small, only 3 percent. One of the factors is that Indonesia has 115 million middle-class people (World Bank, 2019) whose buying power is sufficient to turn the economy around.

KOMPAS/AGUS SUSANTO

Ari Kuncoro

ARI KUNCORO,Rector of the University of Indonesia.

(This article was translated by Hendarsyah Tarmizi)