Will Fed rate hikes lead to a recession … again?



The relationship between higher rates and recessions is currently missing a key ingredient: high levels of consumer debt

 

The Fed has begun raising interest rates.

On March 15, the Federal Reserve hiked its overnight lending rate by a ¼ point, taking its target range for Fed funds to 0.25% to 0.50% from 0.0% to 0.25%. Additionally, officials indicated that a total of seven rate hikes of a similar magnitude could be in store this year. If so, it would take the Fed’s overnight lending target range to 1.75% to 2.00% by year-end — a moderately faster pace than what most forecasters were expecting.

Higher interest rates should slow the pace of economic activity. But will interest rates rise enough to send the economy into recession?

 

Why some investors are concerned

One only needs to look at the chart below for an idea of where recession concerns emanate.

Four of the last five rate hike cycles were soon followed by recession (to be fair, the pandemic-induced recession of March 2020 shouldn’t count). Will we see the same again? Not necessarily, in our view. 

 

Source: FactSet

 

This time IS different

Usually, the Fed can slow the economy via higher interest rates because people have been borrowing money to spend. Reduce that propensity to borrow by raising rates and it negatively impacts spending. Consumers pull back on their spending, businesses follow suit and there you have it: a recession.

But what happens if consumers have not been borrowing to spend? As seen in the chart below, consumer debt burdens are currently very low, which means consumers have not been borrowing excessively to spend.

Yet each of the last four recessions coincided with high levels of consumer debt. High and rising debt burdens have preceded three of the last four recessions (the pandemic-initiated recession being the only outlier). But without high levels of borrowing, this “translation mechanism” for higher interest rates to slow economic growth is currently weak, in our view.

 

Source: FactSet

 

Bottom line

To be sure, higher rates will slow the economy — but the current low levels of consumer debt, helps to neutralize the threat of an economic slowdown, in our view. We could still have a recession — there are several key threats that could easily go awry: Russia/Ukraine, further supply chain problems, a renewed COVID threat or (most notably) the Fed could still hike rates too far and/or too fast. But overall, we believe the most likely scenario is still one in which we avoid a recession.

 

Have concerns? Reach out to your financial advisor

If current market conditions are giving you pause, it may be time to connect with your financial advisor. As always, they are here to help ensure your investment portfolio remains diversified and consistent with your risk tolerance, time horizon and asset allocation targets.