Recession as the “Hard Medicine” of World Inflation


Recession as the “Hard Medicine” of World Inflation

By: Prof. Ari Kuncoro, Ph.D., Rector of UI and Professor of FEB UI

KOMPAS – (19/7/2022) The United States Central Bank or the Fed raised its benchmark interest rate on June 15, 2022. The Fed tried to control US inflation which reached 8.6 percent in May, the highest since 1994. Many are worried that this policy will be overdosed and will bring the US into a deeper recession. The problem is that the Russia-Ukraine war has disrupted world production.

The standard recipe for lowering inflation is to “reset” the economy by lowering the demand side of society. That is done by reducing the expansion of the money supply, raising the central bank’s benchmark interest rate, or using other instruments to tighten liquidity.

That way, people, both consumers, and companies, reduce their spending. However, a recession comes at a cost, namely an increase in unemployment, which needs a strategy to minimize (Okun, 1978).

Inflation and behavior change

With such a high inflation rate, the Feds insisted on raising the benchmark interest rate. The impression of being “hard medicine” is evident from the magnitude of 75 basis points, and there is a possibility of it happening again in July as June inflation reached 9.1 percent.

There are several reasons for such a high rate hike. First is the issue of credibility and reputation (Persson & Tabellini, 1994). The Feds want to improve its image with a more hawkish response to inflation. The Feds is considered too slow (behind the curve) in raising the benchmark interest rate after accommodative monetary policy during the pandemic. With liquidity piling up in the community, the benchmark interest rate hike should have been done earlier.

Second is the declining consumer purchasing power. A recent survey by CNBC US examined the impact of inflation on the upper middle class who earn at least USD100,000 per year. As a result, demand destruction is already evident.

About 65 percent of respondents were so concerned about high inflation that they changed their behavior. As many as 77 percent admitted to reducing eating out, 69 percent reduced seeking entertainment outside, and 63 percent reduced travel.

The survey also showed that 55 percent had reduced big-ticket items, such as electronic devices and furniture, and 45 percent would not buy a car. If the upper middle class is like this, the inflation burden for minorities could be doubled (Torbecke, 2001). This pessimism and concern can make the expectation of a recession come true (self-fulfilling expectation) due to the chain reaction of downward spiraling public spending.

Recession Outlook and Global Impact

A CNBC US survey on several US CEOs in early May predicted that a recession would come in mid-2023 with a probability of more than 50 percent. However, the prediction seems conservative as the impact of the Feds’ interest rate hike has already started to show.

In the US, the prices of US stocks on Wall Street fell. Some other early signs also appeared in the weakening of several indicators, such as home sales, consumer confidence index, and copper prices.

Technically, the definition of a recession only occurs if there is negative growth for two consecutive quarters. US growth has slowed dramatically to 1.6 percent in the first quarter of 2022. Therefore, the second quarter growth data that will be released at the end of July is of global interest. As the world’s locomotive, although the current recession is still a prospect, the impact of the Feds’ interest rate hike will spill over to the world economy through recession, expectations, or other channels (Ahmed et al., 2021).

The global impact of the Feds’ policy is already visible on international oil and commodity futures exchanges. The global oil and commodity futures market trades securities of future delivery contracts, therefore prone to be affected by forwarding expectations.

Commodity futures exchanges can influence the physical market, which is determined by supply and demand. Since the announcement of the US interest rate hike, the price of WTI oil plummeted from 119 dollars per barrel through the psychological barrier of 100 dollars to 96 dollars per barrel within a month.

Other commodities have also been affected. Wheat prices, for example, fell from nearly $13 per bushel in mid-May to $8 per bushel in mid-July. Meanwhile, palm oil fell from around 7000 ringgit per ton to 3900 ringgit.

For the US, the easing of global inflationary pressures is a bonus. The policy of raising benchmark interest rates was initially intended only to reduce domestic demand, resulting in a spillover of lowering prices on global commodity futures exchanges through the recession expectation channel. That eventually affected the production side in the US and the world (Roldos, 1995).

Policy Implications

Although global inflationary pressures are easing, the problems do not stop here for other countries. The fall in global commodity prices caused financiers who had been playing on the world’s futures exchanges to switch to safer financial assets, adding to the return of capital to the US.

As a result, the dollar index rose to almost 109, a 20-year high. As a result, other currencies weakened. The euro, for example, has depreciated beyond the parity of one dollar equals one euro for the first time in two decades. That makes inflationary pressures that initially came only from commodity prices increase with imported inflation due to currency depreciation. For this reason, the European Central Bank (ECB) intends to increase the benchmark interest rate at the end of July and September.

The rupiah was also affected; from Rp 14,600 in early June, it broke Rp 15,000 in mid-July. However, it then stayed at around Rp 14,990 per dollar. The impact can be seen in June inflation of 4.35 percent, the highest in the last five years.

With the expectation of a firmer dollar index, various options can be taken, including raising the benchmark interest rate to prevent imported inflation and excessive capital outflows. Every policy has its pluses and minuses. An interest rate hike may increase the cost of funds. However, it is expected to be borne by an economy that is picking up after the pandemic subsides, relying on public demand that has been held back in the travel, trade, tourism, and accommodation sectors.

The caveat is that too much rupiah depreciation risks causing excessive inflation and weakening domestic demand. The good news is that the IMF predicts Indonesia’s chance of recession is small, only 3 percent. One factor is that Indonesia has 115 million middle-class people (World Bank, 2019) whose purchasing power, if inflation is controlled, is sufficient to turn the economy around.