Interest rates are up again, but are we in a Recession?
fed funds rate, inverted yield curves & the economy
"Fed goes big again with third-straight three-quarter-point rate hike"
Reads the CNN headline. If our attention spans allowed a longer headline, the bulletin would read:
"The Federal Reserve (Fed) today announced that it will raise the Fed Funds rate by 75 basis points (bps)"
Let’s rephrase it one more time.
The Fed, the central banking system of the United States, is raising the rate at which banks borrow money from each other aka the “Fed funds rate”.
A little better. Now what does the rate at which banks in the U.S. lend money to each other have ANYTHING to do with potentially a global recession? Good question, let's get into it.
The Basics
To understand the impact of rates let's first understand the phenomenon of what’s called a Yield Curve. Yield Curve's are formed by plotting the interest rate offered for bonds across different maturities on a line chart. A Treasury Yield Curve such as the one shown below simply shows the interest rates for government bonds (called Treasuries) issued with different “maturities” i.e. how much extra money will you get as a % of what you lend to the government for different periods of time (1 month, 3 month, 5 Year, 10 Year etc.)
Source: https://www.ustreasuryyieldcurve.com/
Now here comes the interesting (re: confusing) part.
Believe it or not, the shape of the line chart above can give a fairly accurate representation of where the U.S. economy is headed. In normal circumstances the curve you're seeing above is upward sloping i.e. short-dated bonds (bonds giving your money back soon) like the 3 month, 6 month or 1 year bonds offer an interest rate lower than bonds maturing later like the 10, 20 or 30 year bonds. The chart above, in sharp contrast to what you'd expect in "normal" circumstances, shows what's called an inverted yield curve i.e. money you can earn lending your money to the government for 1 year is Higher than the money you can earn lending your money to the government for 10, 20 or 30 years which as you can imagine is NOT normal. Here's why this matters":
An inverted yield curve has predicted a recession 7 times in the past with the average duration between an inverted yield curve and a recession being 14 months.
Soo…are we or are we not in a Recession?
A recession, by it's dictionary definition, is when the GDP growth of a country is in the red (i.e. negative) for the past 2 consecutive quarters. Now looking at the real U.S. GDP growth rates over the past two quarters:
Q1 2022: -1.6%
Q2 2022: -0.6%
You’d say plain and simple, yes? Not exactly and here’s why:
The GDP numbers announced by the U.S. Bureau of Economic Analysis (BEA) are estimates and subject to revision i.e. these numbers can be changed when all confirmed data comes out, and the Q2 number of -0.6% GDP growth is not negative enough to be certain that a future revision could not make it positive. This is part of the reason why Fed Chairman Powell and President Biden both are claiming that the US is not in a recession. Regardless of this, the more important part lies next.
The clue to why the U.S. is not in a recession can be found in an economic health indicator released by the Bureau of Labor Statistics (BLS): the unemployment rate. The unemployment rate which rose to as much as 14.7% during peak Covid i.e. April 2020, currently sits at a very lowly 3.7%, which signals a healthy economy. Now how does one feel a recession.
“Recession is when your neighbor loses his job. Depression is when you lose yours"
On the internet - plenty of people given credit for this quote but I heard it from my Econ. mentor, Bill Addiss
An institution called the National Bureau of Economic Research (NBER) is in charge of announcing when a recession starts and ends and their definition of a recession is broader than 2 quarters of negative GDP growth and is defined as: "a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales".
The fact that they haven't announced a recession probably has something to do with #2.
Again, what does the Fed raising the Fed funds rate have to do with THE ECONOMY?
The Fed raising rates has a direct impact on the economy because leaving aside numbers, the higher someone charges you to borrow money the less you'll borrow or you might NOT even borrow. Who’s borrowing, you ask? Dw, I put together a handy chart of how everybody in the U.S. economy relies on borrowing:
At a high enough interest rate it might not make sense for the the government to take on an ambitious welfare program or the company to borrow to hire more or for you to buy your first-home (yet). Fed raising its benchmark Fed funds rate has a ripple affect across the economy and stagnates overall economic activity.
In addition to interest rates the Fed also has other tools it uses to affect the amount of money flowing through the economy (or to implement it’s "monetary policy") such as creating money (quantitative easing) or destroying money (tapering) but I'll leave those topics for another day.
Enough nerding out, should I care?
I'd say, Yes. Even if we're not in a Recession (yet) we're certainly in what's called an economic depression and factors such as the inverted yield curve talked about above, the prospect of a "lagged" economic response to the rise in rates and a hawkish FED continuing to raise rates to counter inflation means we could soon find ourselves in one.
Take Care,
Rohail
Acknowledgements: I’d like to thank Bill Addiss who’s material has been an inspiration for the above. He can be found on his LinkedIn and https://www.aftraining.co/
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Beautifully explained - what a fun read despite the depressing implications