Henry Hazlett explains the relationship between inflation and recession:
[W]hen an inflation has long gone on at a certain rate, the public expects it to continue at that rate. More and more people’s actions and demands are adjusted to that expectation. This affects sellers, buyers, lenders, borrowers, workers, employers. Sellers of raw materials ask more from fabricators, and fabricators are willing to pay more. Lenders ask more from borrowers. They put a “price premium” on top of their normal interest rate to offset the expected decline in purchasing power of the dollars they lend. Workers insist on higher wages to compensate them not only for present higher prices but against their expectation of still higher prices in the future.
The result is that costs begin to rise at least as fast as final prices. Real profit margins are no longer greater than before the inflation began. In brief, inflation at the old rate has ceased to have any stimulative effect. Only an increased rate of inflation, only a rate of inflation greater than generally expected, only an accelerative rate of inflation, can continue to have a stimulating effect.
But in time even an accelerative rate of inflation is not enough. Expectations, which at first lagged behind the actual rate of inflation, begin to move ahead of it. So costs often rise faster than final prices. Then inflation actually has a depressing effect on business.
This would be the situation even if all retail prices tended to go up proportionately, and all costs tended to go up proportionately. But this never happens — a crucial fact that is systematically concealed from those economists who chronically fix their attention on index numbers or similar averages. These economists do see that the average of wholesale prices usually rises faster than the average of retail consumer prices, and that the average of wage-rates also usually rises faster than the average of consumer prices. But what they do not notice until too late is that market prices and costs are all rising unevenly, discordantly, and even disruptively. Price and cost relationships become increasingly discoordinated. In an increasing number of industries profit margins are being wiped out, sales are declining, losses are setting in, and huge layoffs are taking place. Unemployment in one line is beginning to force unemployment in others. [“How Inflation Breeds Recession“, Foundation for Economic Education, March 1, 1975]
Inflation is a symptom — or early-warning signal — of disruptions that lead to recessions. It does not cause recessions. Here’s some evidence, based on post-World War II experience:
Correlations where the change in CPI leads the change in GDP are uniformly and significantly better than correlations where there is no lead or the change in GDP leads the change in CPI. Further, the correlation where the change in CPI leads the change in GDP by 3 quarters is better than correlations with 1, 2, and 4-quarter lead — but not by much. So there is good statistical evidence on which to base my claim that the change CPI is a leading indicator of recessions.
Specifically, the strongest signal is a rising quarterly change in CPI:
Recessions are defined here, in the discussion that follows figure 1.
The good news is that, as of now, CPI isn’t signalling a recession: annualized quarterly changes aren’t on the rise.