Will steep interest rate hikes cause a recession?

Investors and economists have been grappling with the notion that the Federal Reserve may cause a recession or, worse, a protracted recession through a policy error (i.e., hiking rates too aggressively). As the Federal Reserve sought to tame inflation by hiking the Fed funds target rate in May and June – two of the largest Fed interest rate hikes in many years – some market participants were quick to criticize the central bank for being unduly late in their decisions to raise interest rates. However, other market participants argued that the expeditious pace of the rate hiking cycle would increase the chances of a recession.

The crux of the argument is this: if the Federal Reserve raises interest rates too high seeking to reduce inflation, they may slow the economy too much and increase the risk of recession. Interest rate hikes increase the cost of borrowing for consumers and businesses, which ultimately slows economic growth. Federal Reserve Chair Jerome Powell, in his testimony before the U.S. Senate Banking Committee last month, buttressed the notion that the Fed rate hikes could cause a recession, stating, “It’s not our intended outcome at all, but it’s certainly a possibility.”

At the June Federal Open Market Committee (FOMC) meeting, Powell indicated that a 50 or 75 basis point hike would be the most probable outcome for the next FOMC meeting on July 27. Some investors, however, argue that the Fed may have to raise rates higher and longer, potentially well into 2023. Regardless of the magnitude of the rate hike – for example, a surprise 100 basis point hike instead of the expected 75 basis point hike at the July meeting — the market is trying to digest how aggressive monetary policy will be and when it could possibly end. Answers to these questions may be gleaned by the “fool in the shower” idea, coined by Nobel economics laureate Milton Friedman. Friedman stated that monetary policy operates with long and variable lags, and any change in monetary policy should be done slowly to gauge the effect on the economy. Similarly, when the “fool in the shower” realizes the water is too cold, the fool adds hot water but it takes time for the temperature to adjust. When this doesn’t happen fast enough, the fool turns up the hot water too much, ultimately leading to a scalding-hot shower.

This notion sums up the current debate among investors. Will the Federal Reserve raise rates or reduce its balance sheet too aggressively and thereby cause a recession? It’s important to note the Fed may be raising rates while the U.S. economy is already in a recession. This uncertainty or “recessionary fog” may cause investors to wonder if an upcoming recession will be imminent, shallow, protracted, or something entirely different.