Inflation vs Recession Dilemma for Central Banks

Of course, central banks can’t create and supply fresh barrels of oil in the global economy to make up for the lost supply. And yet typically, in the past when inflation rate has spiked (like in the wake of the Russia-Ukraine war), they have tended to raise interest rates in a bid to reduce the overall demand for any and everything in the economy. To be sure, higher interest rates make it more costly to borrow money, whether it is for buying a new car or home or for setting up a new factory.

So why are central bankers not raising interest rates now when anyone can see how fast rising energy prices will fuel inflation?

The official reason is that central bankers are plagued with “uncertainty” about the likely outcome of this war.
Here’s how: While it is quite likely — and possibly the first order effect of the spike in energy prices — that inflation will go up, if the situation does not improve, there is another risk. It could lead to recession, a scenario where a country’s economic output (called Gross Domestic Product or GDP) contracts for two consecutive quarters. A recession also means a spike in unemployment rate.

Higher prices (which hurt affordability) and a sinking stock market (which takes away a sense of being wealthy that people enjoyed until now) can destroy overall demand in the economy. As the demand for goods and services craters, unemployment will likely rise. Raising interest rates in such a situation can worsen the slide and tip over an economy into recession.

Mixed outlook so far

At the moment, it is unclear the main outcome of the current war is unclear: A spike in inflation or the cratering of demand.

During the Covid pandemic, for example, the bigger challenge faced by these developed economies was in the form of a crash in overall demand, with oil prices going below zero at one point. Typically, when demand collapses, so does inflation because prices fall in the absence of robust demand. This problem was remedied by governments providing income support to people.

But in the current scenario, it is entirely possible that energy price increase spikes inflation while also killing demand as people again face a cost of living crisis.

So here the essential problem before policymakers: Raising interest rates may arrest inflation but doing so also involves killing demand. On the other hand, cutting interest rates (as President Trump has again demanded yet again), risks fuelling inflation.

All this confusion came across in the US Fed’s latest Summary of Economic Projections (SEP). The SEP is presented four times each year. In each SEP, members of the Fed’s Federal Open Market Committee (or FOMC), the key interest rate setting body, share their outlook on the key metrics of the economy.

This SEP threw up a confusing picture. FOMC participants raised their projection for both GDP growth and inflation in 2026. But what complicated the picture even more were the charts mapping what the participants believed were the “risks” to their projection; in other words, do they think the US economy will likely undershoot or overshoot their projected number.

Look at the CHART 1, which shows that more members (since December 2025 SEP) of the FOMC believe that the downside risks to GDP growth have increased.

CHART 1.

Similarly, CHART 2 shows that more Fed members believed the risks to the unemployment rate going up had also increased.

CHART 2.

CHARTS 3 and 4 show that more FOMC members (as compared to December) believe that the risks to inflation and core inflation (inflation rate excluding the prices of food and oil prices) have also increased.

CHART 3.
CHART 4.

Of course, there is no rule that only one of these variables can worsen at a time.

The worst combination for central bankers is to have both the risks materialising: if there is higher inflation while also lower growth. That is also called “stagflation” (stagnant growth and high inflation).