What Causes Inflation, and Is It Followed by a Recession?

What Causes Inflation, and Is It Followed by a Recession?

The prices of many goods have risen in recent months. Talk of inflation is on everyone’s tongue. Read below how inflation originates, when a recession arrives, and what that means for stock markets.

What Is Inflation?

Inflation occurs when there is a broad increase in prices and one receives fewer and fewer goods for the same amount of money as before. Whoever places the same items in a shopping cart every week is bound to have noticed in recent months that he or she has had to pay quite a bit more at the checkout than in previous years.

The increase in inflation rates has substantially driven up the prices of goods and services. The inflation rate in Switzerland stands at a moderate 3% thanks to the strong Swiss franc, but surrounding countries and the USA are contending with annual inflation rates of up to 10% and higher.

How Does Inflation Originate?

There are three main causes of the current rampant inflation rates, which are stoking fears of a recession:

1. The Policy of Cheap Money in the Aftermath of the Great Financial Crisis

One major reason why prices are rising at the moment stems from the years following the great financial crisis of 2008. At that time, central banks in the USA, Europe, and Switzerland lowered interest rates as far as possible to stabilize economic systems. They thus made money cheap to borrow. Suddenly, many people could afford to buy or build a home because mortgages were cheaper than ever.

It also became easy for businesses to obtain credit and other funding. This stimulation of economic activity even went so far as to impose punitive negative interest rates on those who wanted to leave their money parked in a bank account instead of spending or investing it. That was a first in history. Central banks achieved their aim: the cheap money turbocharged economic activity and sparked a flurry of construction orders, and materials were ordered, income was generated, and consumer spending was strengthened.

However, this policy of cheap money caused the money supply to grow faster than the supply of goods available to consumers. Leading theorists like US economist Milton Friedman postulate that excessive money supply growth always results in rising prices and paves the way for inflation.

2. Disrupted Supply Chains and Production Stoppages during the Pandemic

In 2020, the global COVID-19 pandemic halted the production of goods and disrupted international supply chains. During the ensuing lockdowns, manufacturers and service providers were barred from operating.

Switzerland and many other countries responded to the crisis by enacting generous subsidies and tax breaks to compensate citizens for their lost revenue and income. However, this threw the macroeconomic balance between supply and demand out of joint because while supply – i.e. the sum of goods and services produced by a national economy – shrank, demand – i.e. consumers’ needs for goods and services – stayed the same.

A disequilibrium of this kind ultimately drives up prices. One good example of this is the market for used cars. According to the Swiss price comparison portal Comparis, worldwide production curtailments and supply-chain problems have caused the supply of used cars to shrink by 29% since the outbreak of the pandemic while prices for used cars have climbed 28% during the same period.

3. The Energy Crisis Caused by the War in Ukraine

At the start of year three since the outbreak of the COVID-19 pandemic, Russia attacked Ukraine and cut oil and natural gas supplies to Europe. That quickly triggered enormous energy price hikes and additionally fueled inflation.

Moreover, leading European countries’ frantic efforts since then to free themselves from Russian energy dependence have resulted in increased spending on the procurement of alternative energy sources (decarbonization), which likewise has driven up prices.

What Works against Inflation?

Interest-rate hikes by central banks are an antidote to rising inflation rates. They make borrowing more expensive and thus reduce the supply of money in circulation. This should have a damping effect on inflation because when credit and loans become more expensive again, businesses and consumers invest and consume less, which enables the imbalance between supply and demand to return to a sound equilibrium.

How Does a Recession Come About?

However, interest-rate hikes have the undesired side effect of suppressing economic activity. Less consumption and less investment quickly cause macroeconomic growth to decelerate. When the sum of all goods and services produced by a country (gross domestic product) contracts year-on-year for two consecutive quarters, the national economy finds itself in a recession under the official definition of the term. A rising unemployment rate then looms because businesses that sell less soon have to lay off employees.

How Do Stock Markets React during a Recession?

When a country goes through a recession, which historically lasts eight to 18 months on average, the daily business and economic news is mostly disillusioning because it is filled with talk of bankruptcies and unemployment, distressed home sales, and growing welfare rolls. News about the stock market then often gets drowned out because it is difficult to convey why news from the real economy is so dismal while stock prices often have already begun to rise again on securities exchanges.

That happens because while businesses contend with the ongoing recession in their day-to-day operations, investors are already evaluating the future potential for stocks. Not without reason it is often said that “the stock market trades on expectations” – expectations about the future growth of corporate earnings that shareholders of a company would like to profit from in the future.

When investors are confident that a company has the worst behind it, has cut costs, and has adjusted production to the new circumstances, they resume buying shares, and stock prices begin to rise. That explains why financial markets usually do not reflect the actual present state of the real economy, but instead anticipate its future development. That can even happen in the midst of a recession.

When Do Stock Prices Begin to Rise Again?

The inflection point where investor confidence returns and stock prices snap back into a steady upward trend can only be determined in retrospect. Not until the data paint an unequivocal picture does it become clear when the “downturn on the markets” ended, the “turnaround was achieved,” or “the market found a floor.” The lexicon of financial reporting has many idioms for this inflection point even though no one knows when it is truly reached.