Is a Recession Looming? It Depends on the Fed's Action...

This article was originally published in the Richmond Times Dispatch on February 14, 2022. 

Whispers of a potential upcoming recession have been quietly discussed. Few observers have mentioned the possibility, but no one yet has used the "R" word or even put recession in their most-likely forecast.

Why are economists even thinking about recession?

The main reason is that we just don’t know how much the Federal Reserve will raise interest rates to get inflation back to its previous target of 2%. Inflation was running 5.8% on a year-over-year basis in December, based on the Personal Consumption Expenditure Price Index, which is the Fed’s preferred inflation measure. 

Consumer prices jumped 7.5% in January compared with 12 months earlier, the steepest year-over-year increase since February 1982, the Labor Department reported Thursday. Core inflation, which excludes volatile food and energy, rose 6% in January.

An aggressive rate hike would slow down the economy. An increase in inflation is bad for the economy because not only does it eat away at consumer spending power, but it causes consumers and businesses to change their behavior.

For example, builders may stockpile wood or steel in advance of prices going up further. If the economy took a downturn, stockpiling of goods would prolong a recession because once the economy started growing again, builders would not need to purchase more inventory from manufacturers until they worked off their current supply.

Many observers are concerned that the Fed waited too long before raising interest rates to bring inflation under control. It typically takes six to nine months or longer for interest rate increases to work their way through the economy.

The Fed has indicated it will start raising the federal funds rate target at its meeting in March. The federal funds rate target, which is the overnight rate banks use to lend to each other, is the only rate the Fed can directly change.

However, as that rate goes up, so do rates with short maturities such as the 3-month Treasury bill or the 2-year Treasuries.

Raising the federal funds rate will eventually affect rates such as 5- or 10-year notes which many consumer-related interest rates are based on, such as car loans and mortgages.

Some economists are looking for the Fed to raise rates at every one of its remaining meetings in 2022 which could put the federal funds rate target at 1.75% by year-end.

That would have a direct impact on the affordability of automobiles and housing in the consumer sector as well as plant and equipment in the business sector.

The interest rate for a four-year loan on a new car was 4.5 percentage points above the effective federal funds rate in November. If that spread held constant and the Fed raised the funds target to 1.75% by year-end, that would put the interest rate for a new car at 6.25%. That would mean the monthly payment on a $30,000 loan for a new car with a four-year term would go from $685 today with interest rates at 4.58% to $708 with the new higher rate. The higher payment could make new cars less attractive financially for some consumers.

Similarly, mortgage rates would rise as well. In fact, the 30-year conventional mortgage rate already rose almost three-quarters of a percentage point in the last 14 weeks to 3.69% on Thursday, mortgage buyer Freddie Mac reported. A year ago, the long-term rate was 2.73%.

These increases in interest rates will slow down economic growth.

The concern, some observers note, is that the Fed will have to raise the funds rate target more than expected over the next year or two - and that can push the economy into recession.

On the positive side, consumers, whose spending makes up about 70% of gross domestic product, have accumulated sizable savings during the pandemic, so they have plenty of spending power. Also, the unemployment rate continues to fall which gives more people money to spend.

The bigger question is how fast will the inflation rate come down?

If the Fed is right, then the pace of inflation will come down relatively quickly as supply chain issues resolve themselves later this year and early into next year. Also, wage increases may ease as more people come back into the labor force after the spread of the coronavirus recedes.

If the Fed is wrong and inflation remains stubbornly high, then interest rates will continue to inch higher and the probability of a recession will rise as well.