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Will the Fed Cause a Recession? The Relationship Between Inflation and Interest Rates

August 01, 2022

The Labor Department’s Consumer Price Index rose 9.1% in June compared to a year before, the fastest pace in almost 40 years. While this number is certainly concerning, it is not all that surprising to those who go to the grocery store, pump gas, or buy just about anything. Prices are going up. Our article from January, The Impact of Inflation on Your Financial Plan, did an excellent job explaining what inflation is and how it can impact our lives and future planning, but now let’s look at the relationship between inflation, interest rates and the probability of a recession.

Inflation occurs when too much money is chasing too few goods. The Federal Reserve (Fed) works to control inflation by influencing interest rates. When inflation is too high, the Fed typically raises interest rates to slow the economy and bring inflation down. By raising interest rates, the Fed is making it more expensive to borrow money. In 2022 the Fed has so far raised the interest rate a total of four times with the most recent increase (0.75%) at the end of July. But discouraging business and consumer spending while monitoring healthy employment and economic growth is a delicate balance. An economic slowdown with a decline in the inflation rate could deteriorate into an outright recession.

During a recession, the economy struggles, people lose work, companies make fewer sales and the country’s overall economic output declines. Commonly, a recession is defined as two consecutive quarters of economic decline. So, by that definition, as of July 28 when the second quarter gross domestic product (GDP) fell 0.9%, following a first quarter decline of 1.6%, we have now fallen into a recession. But, according to the National Bureau of Economic Research (NBER), the organization generally recognized as the authority that defines the starting and ending dates of U.S. recessions, a recession is defined as a significant decline in economic activity that is spread across the economy and lasts more than a few months, along with a variety of other factors. We could very well be in a recession right now but the NBER will not confirm it until after all the data is released, compiled and analyzed.

Even though a recession is considered a normal part of the economic cycle, it’s the Fed’s job to manage its impact. But there is a challenge, since there is a lag between the rise of inflation and the increase of interest rates to bring it back down, they might go too far, causing a more severe recession. Basically, how do they determine when it is appropriate to switch from increasing interest rates to decreasing them? Once again, a balancing act.

The Fed’s forward guidance about where it expects interest rates and inflation to be has become a focal point for financial markets. Financial markets may overreact to a piece of information released by the Fed if there is not a consensus for a final goal. Long term interest rates have risen substantially this year which reflects the changing views in the markets as to where the interest rates and inflation are going to be in 1 or 2 years. The constant over-analysis of every word coming out of the Fed coupled with our societal need for instant information can often lead to misunderstandings. The messages from the Fed can mean different things to different people and can be misinterpreted. Investors are right to be weary of a looming recession as 8 of the past 9 tightening cycles have ended in recession1. The more difficult part of the job is judging how long it takes for a rate hike to fully trickle through the economy. With so many factors involved, it is easy to find a scapegoat in the Fed. We need to point the finger at someone and the Fed is the easiest target. Will the Fed cause a recession this time? Quite possibly. The depth and length of the recession is what will be more concerning. Economists currently place the odds of a recession near 50% which is about the same as flipping a coin2.

So, while it is still unclear that rising interest rates will bring on a recession it is important to be prepared. For guidelines on how to combat inflation and how to prepare you and your family for possible recession, contact Ciccarelli Advisory Services. Thank you for your confidence and your continued commitment to Ciccarelli Advisory Services.