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Will Fed Rate Hikes Cause Recession?

Will Fed Rate Hikes Cause Recession?

October 03, 2022

Understanding the Fed Funds Rate

There is lots of talk about interest rates in the media these days, “How much will the Fed raise rates?” “How many times will the Fed raise rates?” “Will rising Fed rates cause a recession?”

So, I offer some context.

FIRST what is the Fed Funds Rate? The Federal Open Market Committee (FOMC) suggests a target rate eight times each year for funds loaned between commercial banks overnight. The rate is a suggestion, but generally, banks follow along. In July 2022 the FOMC raised the rate by 0.75% to 2.25% to 2.5%. So, the PRIME rate which is often used for variable lines of credit, is generally 3% higher than the Fed Funds rate, or about 5.25% right now. This makes a 2.25% increase in interest rates over the last year. That’s a lot. But, I’m old enough to remember December 1980 when the PRIME rate was 21%, so 5.25% doesn’t seem so bad.

SECOND How many more Fed Fund Rate hikes should we expect? Well, nobody knows. There is plenty of speculation. If you turn on any financial “news” channel you are likely to hear some speculation a couple of times an hour most times of the day or night.

Some officials indicate that several more rate hikes of a similar magnitude could be in store in 2022 and 2023. The current speculation is that the Fed Funds Rate will top out at around 4% some time in 2023. If this is correct it’s a pretty fast rate of increase.

THIRD How will the Fed decide whether to raise again or not? Well, in recent comments, Federal Reserve Chairman Jerome Powell said that the central bank will “use our tools forcefully” to fight inflation. So, if prices continue to rise, the Fed is likely to continue to increase interest rates. The hope is that this will reduce demand for goods and that prices will fall as a result.

Impact on Inflation and The Economy

What is an interest rate rise supposed to do to inflation?

 Well, first what’s inflation? Generally, inflation is the rise in overall prices for goods and services. You experience inflation when you go to the store and items cost more today than they did the last time your were at the same store.

So . . . if you raise Fed rates, the cost of borrowing is higher, so fewer people borrow, so fewer people can afford to buy all the stuff they want, so sales fall, so companies cut prices to get more buyers, so company profits fall, so companies start to lay off workers to reduce costs. If enough companies cut back, the economy will show a negative rate of growth. Two quarters of negative growth is one definition of a recession.

So, the goal of Fed Rate increases is to SLOW the economy but NOT STOP the economy. It sounds pretty simple, but is it?

Doesn’t An Increase in Fed Rates CAUSE a Recession?

Well, it depends. It can, but it doesn’t ALWAYS. The chart below shows that four out of the last five times the Fed began to hike rates, a recession followed. One of those recessions was the COVID Crash of March 2020. Maybe that one shouldn’t count.

Fed funds and recession

Is This Time Different?

As I mentioned above, part of the mechanics of Fed Rate increase is that higher interest rates EQUALS less spending. This has often worked because historically U.S. consumers have not saved much and did a lot of their spending with borrowed money.

But right now, U.S. consumers have about $4.57 trillion in money market savings as of 31 August. That’s quite a bit by historical standards. The U.S. consumer savings rate remains at 5.1% in June 2022.

 Personal saving rate in United States

And in addition to the cash in savings, Americans have been paying down their credit cards and other loans. This chart shows that rates of borrowing are lower than usual.

 Finance chart

So, what happens if the Fed raises interest rates, but most people are still living off cash? It probably means that the trigger to throw the economy into recession is pretty weak. But we will have to see.

With a war in Ukraine and turmoil in world energy markets as many countries rethink buying fuels from Russia, there are plenty of variables at work.

If all this talk about interest rate increases and recessions makes you concerned about your financial plans, don’t hesitate to CONTACT ME, I would love to talk with you.

As a fiduciary, fee-first, CFP® professional, I can help you make great retirement income choices and develop a holistic financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will be better prepared to understand your options at every step along the way.

Yes, I am a CFP® professional. I’m always a fiduciary and I work on a fee basis. And yes, I’m still taking on a few great families to be part of my financial planning practice.

If this article has you thinking about your own circumstances, contact my office at rdunn@dunncreekadvisors.com. I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.