To cause a recession, short-term interest rates need to be much higher. Despite the Federal Reserve’s rate-raising, the inflation-friendly, easy-money environment is still in place. Here is the situation…
The negative real interest rate environment continues
Because the Federal Reserve started in the 0% basement, it had a long way to go before short-term interest rates crossed the inflation line. At that point, the “real” (inflation-adjusted) interest rate goes from negative to positive.
Why is this a recession issue? Because tight money (with higher real interest rates) is a precursor of recessions. The history of interest rates, inflation, and recessions shows the link.
Here is a look at the Federal Funds interest rate compared to the 12-month trailing CPI (less food and energy) inflation rate. Tight money is when the interest rate is well above the CPI, no matter what that inflation rate is.
Perhaps easier to see is the difference between the Federal Funds rate and the CPI – the real interest rate. The current, still-large negative real interest rate is clearly visible, showing that easy money is still at work.
Note that every recession (except the Covid-19 shutdown) is preceded by the Federal Fund rate rising well above the trailing 12-month inflation rate. While a recession doesn’t automatically follow a tightening, every recession has been preceded by one.
So, when will rates be high enough to cause a recession?
Looking at history, a real rate of over 2% would be high enough to cause concern. Assuming the inflation rate settles at around 5% in 2023, the Federal Funds rate would need to be over 7% to produce recession worry. Clearly, as the graph below shows, today’s Federal Fund rate range of 3% to 3.25% is far below that point.
The bottom line – Interest rates aren’t everything
Notice in the graph above that high real rates don’t automatically produce recessions. For a recession (AKA, negative reversal) to take hold, there also needs to be a fundamental reason for it to occur. Typically, such are economy, financial and/or investment excesses or imbalances that require correction. Otherwise, the higher real rates can simply be caused by a healthy demand for capital.