How Interest Rate Hikes May Trigger a Recession

The history of economic development cannot be understood without the importance of recession periods.

Recessions are often the result of the excess accumulated in previous years. Creative destruction after a period of excess used to drive a stronger recovery and continued economic development. That was until risky assets became the biggest concern for policymakers.

From the late seventies and early eighties US housing slump and automobile industry crisis to the technology and housing bubble burst there is a clear process of causation created by interest rate policy. Constant decreases in interest rates lead to excessive risk-taking, complacency and accumulation of exposure to increasingly expensive assets under the perception that there is no risk. Bubbles become larger and more dangerous because interest rates are kept abnormally low for a prolonged period and it disguises risk, clouding citizens’ and investors’ perception of danger in elevated valuations. Cheap money leads to generalized and dangerous risk exposure.

After every recession, central banks keep rates too low for too long even in growth periods because policymakers’ fear asset price corrections, and this leads to complacency and the creation of bubbles everywhere. Once policymakers decide to raise rates, they often cause a recession because the amount of risk taken by even the most conservative investor or household is simply too high. By the time that central banks decide to finally raise rates the bubbles are already more than a market headline, but a dangerous and widespread accumulation of risk that negatively affects millions of unsuspecting citizens.

The question is what is worse, the rate cuts or the rate hikes? Rate hikes tend to trigger recessions, as Jesse Colombo or Lance Roberts have shown in numerous charts, but what causes them is previous extraordinary levels of accumulated risks throughout the economy.

The boom-and-bust cycle is more severe and frequent, as we have seen since the late seventies. That is why central banks never truly normalize policy, rates remain in negative territory in real terms. And investors know it. That is why there is a perverse incentive for households, businesses, and investors to buy any correction.

The fear of interest rate hikes allows us to analyse what has happened in other similar periods.

Between 1985 and 1990 the Fed raised rates 325 basis points and the S&P 500 rose 45%. The rate hike cycle drove emerging economies like Mexico to the ground and states like California went bankrupt.

Between 1993 and 2000 the Fed also raised rates by 325 basis points and the US stock market shot up 225%. In that period, we saw the Tech bubble burst and the early 2000s recession. In the 2003 to 2007 period the Fed raised rates by 375 basis points and the market rose 30%. It brought the great financial crisis and the housing bubble burst.

Between 2015 and 2020, rates rose 200 basis points and the US index advanced 65%. In that period, in 2018, we saw the Fed change its rate-hike course rapidly after a market correction.

Will the Federal Reserve change its rate hike plan this time? History shows us that central banks care much more about risky assets – stocks and bonds – than they say and certainly a lot more than they do about inflation.

At the beginning of 2016, faced with a cycle of expected rate hikes, the S&P500 corrected 11.3% until January 20th. The Federal Reserve ended up raising rates just once that year despite announcing four hikes. Why did they change? “Geopolitical risk and weakening financial conditions”. Exactly what is happening now.

In December 2018, after years of a bull market, the US stock market fell by 9%, and on January 3rd, 2019, it corrected another 3.5%. The next day, the Federal Reserve announced that it was “going to be patient” and stopped its rate hike path on its tracks.

It is true that inflation was not 7% ​​then and the Federal Reserve may probably be more tolerant of a market correction than when the US CPI was 3%, but we cannot forget that history shows us that central banks always maintain looser conditions than it seems from their messages and headlines.

The evidence of the United States economic slowdown is everywhere. Retail sales, job creation, stagnant labor force participation, declining real wages and slowing capital expenditure. To all this we must add the continued rise in energy commodities due to the Ukraine tensions.

The Federal Reserve is aware of the “bubble of everything” created in recent years and the elevated levels of debt throughout the economy. Unfortunately, the Fed has already left rates low, and asset purchases high, for too long to prevent an inevitable negative economic effect. Even worse, the solution will likely be to repeat the same policies that created the conditions for excess.