Surprise, the Fed is Not a Wrecking Ball After All
Former JPMorgan Chase Global Chief Economist and Current BrightQuery Chief Economist
Photo by Isaac Brekken on Getty Images
On February 4, 1994, the Federal Reserve began to formally announce changes in the federal funds rate to signal a more restrictive/accommodative monetary stance. Using this data, we examine whether increases in short-term policy rates have led to higher unemployment rates and slower economic growth, given that such conditions are usually considered essential prerequisites for reducing inflation pressures.
Labor Markets
Unlike Miley Cyrus, the Fed has not entered U.S. labor markets like a wrecking ball whenever it has raised short-term rates to combat inflation since it began announcing its policy rate decisions in 1994. Except for the 1999 monetary tightening cycle, which sought to dampen the effects of the dot.com boom, U.S. unemployment rates have not risen immediately after the Fed began to raise its federal funds rate!
While many investors have been surprised that the U.S. unemployment rate has not increased since the Fed began raising interest rates, history does not support that outcome in almost every monetary tightening period. The only caveat is that the magnitude of the current rate hike (e.g., +500 basis points) has exceeded every tightening cycle in our sample, including the one before the start of the Global Financial Crisis (e.g., +425 basis points).
Source: U.S. Bureau of Labor Statistics and the Board of Governors of the Federal Reserve
Real GDP
Investors and the Federal Reserve have also been conditioned to expect higher policy rates would trigger slower real GDP growth, deemed essential for lowering inflation. Yet the evidence is also unconvincing on this front, as real GDP growth has usually accelerated one year after a monetary tightening cycle starts.
Source: The Board of Governors of the Federal Reserve and Bureau of Economic Analysis
Even when real GDP growth has slowed, such growth has remained at or above the U.S. potential growth rate. This growth rate estimates how fast the U.S. economy can grow using all its available resources without triggering inflation or deflation. The non-partisan Congressional Budget Office (CBO) projects that after peaking at 2.3% in Q1 2026, from its latest reading of +1.8% (Q4 2023), “real potential GDP” growth will stabilize around +1.8% in 2034.
Economic Growth Tailwind
A positive factor that may help the U.S. economy over the next decade was also revealed by the CBO, which estimates that the effects of immigration will boost U.S. real GDP by $7 trillion over the next decade. Interestingly, a recent St. Louis Fed study revealed that from the start of the global pandemic through Dec. 2022, we lost an excess of 3.3 million workers due to “early retirement.” Although the non-partisan CBO does not take a position on immigration, they explain that the influx of immigrants will increase the U.S. labor supply, lift aggregate demand, and generate higher economic output. As always, we leave it to the reader to decide their position on how they feel about immigration. In prior analysis, we have suggested alternative ways the U.S. economy can increase its economic output (for those opposed to immigration), namely through increased use of artificial intelligence or supporting government initiatives that promote increased productivity. Both initiatives would lead to increased economic output using fewer labor resources!
Do Rate Hikes Lead to Recessions?
Yes, but not as quickly as one might think! As a result, it may be too early to bring in the “No Recession” Marching Band since we have never seen a U.S. recession begin within 12 months of an initial policy rate hike. To be sure, 50% of the time that the Fed has raised rates (since 1994), a recession began sometime during the fourth year after the Fed initially raised its policy rates. Only in 1999 did a recession begin and linger during the second and third years after the Federal Reserve’s initial policy rate hike.
Source: National Bureau of Economic Research Business Cycle Dates
Inflation
Still, many had expressed concerns about the arduous task the Fed faced when it began to raise rates in March 2022. Back then, the Consumer Price Index (CPI) was rising at a yearly pace of 8.5% and later peaked at a growth pace of +9.1% (June 2022). That is the highest inflation rate observed during our sample period at the start of a rate hiking cycle! Naturally, the outsized inflation rate caused many investors to assume that massive tightening would be needed, which prompted them to assign a higher probability of an above-average grade recession!
Instead, the economy experienced a mini-banking crisis in March 2023, met by an aggressive regulatory response. The FDIC rushed in to find distressed buyers willing to purchase the failed banking institutions at a significant discount. At the same time, the Federal Reserve created an emergency banking facility that provided liquidity using the face value of their government securities portfolio without any haircuts as collateral. The outcome was a non-systemic banking crisis.
Why Hasn’t the U.S. Slipped into a Recession Yet?
One reason was the massive fiscal stimulus unleashed into the economy during the global pandemic. The fiscal deficit as a percentage of GDP rose from a low reading of 2.5% (pre-Covid-19) to 15% during the global pandemic. This served as a massive economic boost and likely prevented a recession.
On the monetary front, the Federal Reserve more than doubled the size of its balance sheet from Jan. 2019 to May 2022! That provided an avalanche of liquidity that supported the economy and its financial markets. Given these developments, no one should be surprised that the economy failed to slip into a recessionary mode despite the adverse shocks that it has encountered in recent years!
Others have pointed out that the global pandemic generated massive FOMO (fear of missing out) effects from consumers who have opted to exceed their spending thresholds after realizing how fragile life could be for everyone. The fact that we have 1.5 jobs available for every unemployed individual, according to the Bureau of Labor Statistics (JOLTS Survey), has also continued to support consumer spending and reduced the risk of slipping into a recession!
Summary and Concluding Thoughts
Despite the conventional wisdom that monetary tightening cycles designed to lower inflation pressures impact the economy like a wrecking ball, the evidence fails to support this view. Instead, the results suggest that the economy continues flourishing during the early stages of an interest rate hiking cycle.
Combining these results with the massive monetary and fiscal stimulus unleashed during the global pandemic may explain why the U.S. economy has thus far avoided a recession. However, history also suggests it may be too early to bring out the “No Recession Marching Band” since the economy mainly slips into a recession only after the third and fourth year following a monetary tightening cycle. Such caution is also warranted when one acknowledges that geopolitical risks continue to pose a credible underlying threat, as evidenced by the rise of oil prices to a three-month high following recent attacks on sea vessels traveling through the Red Sea.