The global economy runs on money, so when the cost of money in the form of interest rates rises rapidly, growth may slow sharply or even give way to a recession.
Whether these consequences mean rates rose too quickly would depend on the particular economic circ*mstances, including an assessment of the cost of raising rates more slowly.
Most U.S. recessions since the Great Depression have followed interest rate hikes by the Federal Reserve. Often the ensuing downturn has forced the Fed to reverse course and start lowering the federal funds rate.
Rapid rate hikes are the likely central bank response to high inflation that might have been fueled by the easier monetary policy adopted earlier. There is no one-size-fits-all measure of how quick is too quick, and no way to know whether policymakers have made optimal tradeoffs between growth and inflation except in hindsight.
Key Takeaways
- Central banks set benchmark interest rates to guide borrowing costs and the pace of economic growth.
- Lower rates spur growth while higher ones restrain spending, investment, and stock market valuations.
- If rates rise too quickly, demand may decline, causing businesses to reduce output and cut jobs.
- Higher interest rates are often the result when a central bank sets out to tame inflation.
Understanding Interest Rates
Benchmark interest rates set by the Fed and other central banks affect borrowing costs for governments, businesses, and consumers. They are monetary policy's primary tools for ensuring maximum employment and modest inflation, and among the most important determinants of the pace of economic activity.
Gradual increases in rates give everyone from homebuyers shopping for a mortgage to CEOs evaluating a big debt-financed investment time to adapt. If rates rise too quickly, they may disrupt economic planning, discourage investment, and unnerve financial markets.
The Fed kept the federal funds rate near zero during and after the 2007-2009 Great Recession, and again during the COVID-19 pandemic.
When Interest Rates Surge
When the Fed raised its target range for the federal funds rate by 75 basis points in June 2022 it undertook the biggest rate hike since 1994. The 1994 increase was part of monetary policy tightening that doubled the fed funds rate to 6% in a year. Yet U.S. GDP growth sped up from 2.8% in 1993 to 4% in 1994. After dipping back down to 2.7% in 1995, economic growth rebounded to 3.8% the following year. It was arguably the only soft landing the Fed has achieved in the last 50 years.
If the analogy still seems encouraging, consider that the 1994 rate hikes came with inflation at 2.6%, compared with 8.6% in the year through May 2022. "Unfortunately, I know of no theoretical framework that can tell us how much we will need to tighten long real rates to get inflation back to target in a reasonable time frame," Minneapolis Federal Reserve Bank President Neel Kashkari wrote in June 2022.
In raising the fed funds rate from near zero in early 2022 to a range of 1.5% to 1.75% by June, the Fed had achieved nearly half the tightening of 1994 relative to the neutral fed funds rate, Kashkari estimated. But he also noted the disparity in inflation, adding the Fed may need to tighten more than it did in 1994 to bring it under control.
At the same time, Kashkari argued the Fed's hard-won credibility on inflation would avoid a repeat of the late 1970s and early 1980s. After the effective fed funds rate rose from 4.7% in early 1977 to more than 19% at times in 1980-1981 amid high inflation, a deep recession ensued. The unemployment rate was near 10% for a year, and elevated for years before and after.
Timing Is Almost Everything
In monetary policy, it pays to have good timing. The economy has to be robust enough to handle the increase in borrowing costs as a result of higher interest rates. If the Fed tightens too quickly, it risks tipping the economy into an unnecessary and deep recession, as happened in 1937-38 with contribution from other policy mistakes. Fed interest rate hikes also have global consequences, often forcing up rates in developing countries.
On the other hand, timing may be irrelevant if high inflation is convincing consumers and businesses that more high inflation is on the way. Unanchored inflation expectations make monetary policy less effective, offering policymakers an unappealing choice between 70s-style stagflation and the recession of the early 1980s.
Like generals, Fed policymakers are susceptible to fighting the last war. In 2020, some Fed officials suggested the Fed increased interest rates too much in 2015-2018, slowing the recovery from the global financial crisis. The Fed's failure to hit its 2% inflation target in those years informed its decision in 2020 to target average inflation over time, and may have led policymakers to underestimate subsequent inflation.
Meanwhile, the Fed has also been blamed for leaving rates too low for too long in 2003-2004, fueling subsequent housing speculation.
Advisor Insight
Mel Mattison,
MoneyComb, Inc., Durham, NC
As with all drivers of financial assets, a very rapid move is generally not a good thing. The markets are interconnected, so if one input changes too quickly, it dislocates other areas. For example, if interest rates were to rise very quickly, it would yield dramatic, negative effects on bond prices and currencies, and stunt growth in the real economy. Companies would suddenly and unexpectedly be hit with higher borrowing costs. This would hurt earnings, increase their cost of capital, and dampen investment.
Similarly, investors would see their net worth plunge if they’re invested in bonds. In theory, this situation would then begin to self-adjust towards lower interest rates. Likewise, the Federal Reserve would also intervene through monetary policy to slow down rate increases.
Why Does Increasing Interest Rates Lower Inflation?
Lower rates encourage borrowing and tend to increase money supply. For example, the lower the interest rate the lower the monthly mortgage payments on a newly purchased house. Conversely, higher interest rates increase the cost of borrowing to buy a home, and restrain other consumption and investment. This makes it harder to raise prices.
How Does Raising Interest Rates Affect the Stock Market?
The stock market is affected by many factors, including corporate earnings and investor sentiment. Low interest rates tend to provide a tailwind for growth, earnings and equity valuations, while high rates present more of a challenge for stocks. The economy's condition is important too. If the Fed is cutting interest rates because the economy is sinking into a recession, the market may focus on the downturn and its risks rather than the benefits of easier monetary policy.
Does Raising Interest Rates Increase Unemployment?
It can have that effect. By raising the bar for investment, higher interest rates may discourage the hiring associated with business expansion. They also cap employment by restraining growth in consumption. If demand drops, businesses may reduce output and cut jobs.
The Bottom Line
The Federal Reserve sets the economy's benchmark interest rates to promote economic growth while keeping inflation low and stable. If the Federal Reserve identifies high inflation as the most serious threat to those objectives, it may increase rates quickly enough to significantly slow growth or cause a recession.
