Of the past 19 rate hike cycles going back over a century, 16 of them have ended in a recession. As the economy undertakes its 17th rate hiking cycle, it is hard to ignore to possible implications of an increasing short-term rate courtesy of the Fed.
The Fed’s latest dot plot projects a target rate of 3% by 2019. As the US economy approaches 95 months without a recession, adding three years to the recovery to achieve the forecast-ed 3% in 2019 would result in the longest recession free period in history.
Rate Hike Cycles And Risks
Every economic cycle is different in its own way, so we can’t assume that since past rate hikes led to recessions, this one will do the same. However, like any policy stance of the Fed, there are of course risks to rising rates. One obvious risk is how the increase in the short-term rate will affect borrowers ability to service debt. Consumers and corporations have been borrowing at low interest rates for years. What will happen if the cost of servicing their debt begins to rise at a sharper rate than income?
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Another potential risk is the equity market. Some argue the low level of Treasury yields we’ve seen over the years, have driven a lot of investors into equities. If these bond yields begin to climb as the Fed tightens, it’s possible the money that was diverted to the equity market goes back into the bond market. In the case that portfolios become less reliant on stocks, how will the market react?
If the Fed does get to 3% by the end of 2019, how much room do they have to cut rates if a recession does emerge? Since the 70’s, the Fed usually slashes the effective rate by around 5% in response to a recession. With the rate at 3%, a Fed cut may put us in negative territory. In the unfortunate scenario where a recession arrives before the target rate reaches 3%, we will almost certainly see negative rates. This recovery has continued to defy historical precedent, so maybe we’ll see another red circle on that chart above.