Coming recession? Odds rise as Fed hikes interest rates

Editor’s Note: Dr. Mike Walden is Reynolds Professor Emeritus at North Carolina State University.

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RALEIGH- Recessions are part of the business cycle. Each economic cycle contains a period of growth – called expansion – and a period of decline, called recession. Since World War II, there have been a dozen recessions. The last recession was in 2020. It only lasted two months, but was very deep.

Bad things happen during recessions. Businesses go bankrupt, workers lose their jobs, the stock market declines, and the federal government goes deeper into debt trying to help the country survive.

Mike Walden (NCSU photo)

One of the most studied questions about recessions is what causes them. The consensus answer is that recessions result from a certain excess that has developed in the economy. Indeed, recessions are the way to eliminate these excesses.

Consider the recession of 2007-2009, the so-called “subprime recession”. Affordable interest rates and lenient lending standards have spurred a boom in home building and home buying. House prices jumped and investors became convinced that investing in houses was a “safe thing”. Unfortunately for buyers, home prices eventually peaked, triggering a sell-off as investors took profits. Those who bought at the top of the price lost large sums of money, as did the financial institutions that backed them. The country nearly experienced a financial collapse similar to the Great Depression of the 1930s.

That’s growth: The US economy grew at the fastest pace in 2021 since 1984

The last recession of 2020, dubbed the “Covid-19 recession”, has an unusual origin. This happened following government mandates for some businesses to close and individuals to stay home to curb the spread of the virus. Policymakers knew the economy would decline as a result, but the costs were deemed necessary to reduce Covid-19 cases, hospitalizations and deaths.

THE COVID LINK

If there is a recession in 2022, there will also be a Covid link. Here’s why.

With the partial shutdown of the economy at the start of 2020 and public institutions such as hospitals facing increasing patient numbers, the federal government began providing unprecedented financial assistance. Stimulus checks to households, expanded unemployment compensation checks to laid-off workers, special payments to households with children, expanded food stamps, broader health care support and special loans to businesses have been provided in several aid programs in 2020 and 2021. These allocations totaled $5.5 trillion.

The financial assistance was so broad and generous that the median household income rose and the poverty rate fell. Many households actually emerged from the worst of the virus in 2021 in better financial shape than before the virus. They were full of money and wanted to spend.

But a problem has arisen as the virus has also reduced the ability of producers to make products and deliver them to consumers. Thus, with robust spending but limited supply, the national inflation rate – which was between 1% and 2% per year as of 21st century – started rising and ended 2021 at 7%, three times the level it had been at for most of the 21st century.

So 2022 started with inflation as a major economic issue for the first time in forty years. Although supply chain improvements will reduce inflation, most experts believe it will be months before supply issues are fully resolved.

Inflation, interest rate

Therefore, the job of reducing the rate of inflation will fall to the country’s central bank, the Federal Reserve (Fed). The Fed will have to reverse its “cheap money” policy followed during the pandemic, when it pushed interest rates to near zero and increased the money supply by 85%. Interest rates will have to be raised and the money supply reduced.

Forty years ago, the Fed faced a similar situation. Following the stimulus provided by the Fed to deal with two recessions in the 1970s, the economy was running at full steam and the annual inflation rate hit double-digit levels for several years. After the Fed raised interest rates and curbed monetary growth, the inflation rate plunged. But the economy did the same when a recession set in.

In the best-case scenario, today’s Fed will be able to slow the economy enough to reduce the rate of inflation, but not so much that the economy contracts, unemployment rises, and a new recession to occur. Unfortunately, the Fed-controlled “accelerator pedal” is not accurate. The Fed never knows exactly how the economy will react when it presses or releases the pedal.

The Fed has strongly hinted that it will raise interest rates in 2022. Watch what they do, because everyone’s economy will be affected. Will a recession be in our future? You decide.

(C)NCSU

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