Written by: Eric Reed, December 20, 2022, https://smartasset.com/financial-advisor/does-inflation-cause-a-recession

Inflation and recession have become the two watchwords for economics in 2022. Over the past year, major economies have experienced some of the highest rates of inflation in decades. Inflation in the U.S. economy alone is the highest it’s been since the early 1980s. This has sparked ongoing concerns about a recession in 2023. Let’s break down how these economic events could affect your personal finances.

Inflation can happen when there is too much money and spending relative to an economy’s productive capacity. Consumers are trying to spend more money in an economy that can’t produce enough goods and services to meet their demand, so instead prices go up.

A recession tends to be defined by an overall slowdown in economic activity. Businesses don’t have enough customers and workers can’t find enough jobs, which slows down buying and spending across the board.

While inflation does not have to trigger a recession, governments try to tame inflation by slowing down all of that spending. Slowing down economic activity doesn’t always lead to a recession, but if that slowdown becomes a self-sustaining cycle it very easily can.

Let’s take a closer look at inflation.

What Is Inflation?

Inflation is the rate at which goods and services get more expensive across the economy. When prices rise overall for equivalent products, this is known as inflation. The reverse happens in deflation, which is when prices fall for equivalent goods and services.

For example, say a gallon of milk costs $4. If across the country, milk rose to $4.40, that would be considered 10% inflation. If the price of milk rose in a single area, or if stores started charging $5 for 1.5 gallons of milk, that would not be considered inflation.

Inflation generally occurs when demand and production meet a bottleneck. Consumers have more spending power and can therefore outpace the economy’s capacity to produce. Ordinarily, when consumers get wealthier, businesses produce more goods and services to keep up with demand. When businesses can’t produce new goods and services, but demand continues to grow, they raise their prices.

This can happen many different ways, but often it’s the result of disproportionate elasticity in the market. Either consumers get wealthier faster than businesses can grow to keep up, or productive capacity falls faster than money can leave the economy.

In the wake of the coronavirus, economists believe consumer wealth beat business growth and productivity fell faster than spending. Generous government support programs stimulated the market with cash at the same time as the pandemic disrupted production and logistics worldwide. This left a highly liquid consumer population trying to buy things from businesses with significantly reduced productive capacity, which has caused inflation.

Economists worry about inflation more than most economic disruptions because it can become a self-sustaining cycle. Higher prices cause workers to demand higher wages to keep up with the new market. Higher wages mean higher costs for businesses, which charge higher prices to compensate. Higher prices draw more money from workers, who need higher wages in response. This cycle can feed back on itself and once it begins, it can be very difficult to stop.

How Does Inflation Affect Consumers?

A little bit of inflation can actually be a good thing. This is important to understand because inflation is almost universally reported as unambiguously bad. In a healthy economy, inflation tends to indicate that consumer spending power is growing faster than the economy’s ability to keep up. This can encourage economic growth and new business formation, as companies try to keep up with rising demand. That, in turn, correlates with rising wages and productivity. This is why the Federal Reserve’s target rate of inflation is 2%, not zero. Some price growth is a good thing.

The problem is degree of inflation. A little bit of price growth can encourage business formation and erodes fixed-interest debt, as loans lose value relative to the value of money. However, the problem with inflation is that it also makes goods and services more expensive for consumers. If inflation gets too high it can make it harder for consumers to afford the same quality of life. They have to spend more and work harder just to buy the same things. At best, high inflation causes people to cut back on luxuries. At worst, they struggle to afford necessities.

At the same time, during periods of high inflation, bank interest rates can fall relative to the value of money. In the same way that inflation erodes the value of debt, this also erodes the value of consumers’ savings. That debt erosion isn’t always good either. When the value of debt falls, banks and investors lose money, making it harder for businesses to find capital and grow.

Finally, if incomes don’t increase in line with inflation a process known as “stagflation” sets in. This is when purchasing power stagnates while prices rise, causing people to lose ground quickly.

All of this is why governments try to prevent inflation whenever they can.

How Are Inflation and Recessions Connected?

There are two connections between inflation and recession.

A recession occurs when there is a general slowdown of activity across an economy. It’s connected with job loss, declining investments, falling stock prices and a shrinking GDP.

Periods of inflation don’t tend to cause recessions in and of themselves. A period of inflation is generally defined by high consumer activity relative to the economy’s productive output. Basically, people have more money to spend than the economy can keep up with. Although, that said, rising prices can indeed sometimes slow down productivity. As prices for raw materials and labor go up, some companies may choose to cut back on their production, which can shrink economic activity overall.

But overall, inflation is generally seen as being linked to too much spending and too much activity rather than the slowdowns that characterize a recession.

This is why governments try to curb inflation by reducing the amount of economic activity overall. In the United States, the Federal Reserve raises its core interest rate to achieve this. By raising interest rates, the Federal Reserve makes lending and borrowing more expensive. This makes it more expensive for many different parts of the economy to function, which slows down economic activity as a whole.

Ideally, by slowing down economic activity as a whole, the government can reduce demand relative to the economy’s productive capacity. This can give prices a chance to stabilize. Although critics have pointed out that raising interest rates makes it harder for businesses to respond to inflation by building new capacity, which would also help reduce inflation.

Slowing down the economy is the main connection between inflation and a recession. To curb inflation, governments try to reduce economic activity until it meets the economy’s productive capacity. If they’re successful, they can slow down the cycle of spending and price increases without causing serious harm. More often, however, slowing down the economy causes businesses to start producing less and laying off workers. This has its intended effect of sucking demand out of the economy but, like inflation, demand reductions tend to be self-reinforcing. That slowdown continues and magnifies, and can lead to a recession.

This isn’t inevitable, but it is common and hard to avoid.

Bottom Line

Inflation causes prices to rise, which can slow down an economy somewhat as both raw materials and labor gets more expensive. However the real connection between inflation and recessions is in the cure.

Governments try to fix inflation by slowing down the economy. When things get too slow, a recession can set in and in some cases deflation.