Will Fed Rate Hikes Lead to a Recession? Why Experts Are Worried – CNET

What’s happening

The Federal Reserve is trying to cool the economy by hiking interest rates without causing a downturn, but experts say a “soft landing” is looking less probable.

Why it matters

With the Fed’s projections to continue raising rates, there will be consequences — most likely an uptick in unemployment.

What it means for you

Soaring consumer prices, tumbling stocks, increased costs to borrow money and the threat of layoffs could prove particularly devastating for low- and middle-income Americans.

The Federal Reserve may be getting hit with a double whammy. Its three interest rate hikes this year haven’t helped with inflation yet, and the increased cost of borrowing money could contract the economy too much, sending us into a recession — a shrinking, rather than growing, economy.

Raising interest rates is the main action the Federal Reserve can take to counter high inflation. When it costs more to borrow — as with credit cards, mortgages and other loans — consumers have less spending power and will buy fewer items, decreasing the “demand” side of the supply/demand equation, theoretically lowering prices. But that hasn’t happened yet.

Inflation remains stubbornly steep — the latest Consumer Price Index data shows an annual rate of 8.6%, a high that’s not been reached in 41 years. Fed chief Jerome Powell has warned that a “soft landing” — 2% inflation with a strong labor market — will not be easy. In an interview with Marketplace, Powell said that it will be “quite challenging to accomplish that right now, for a couple of reasons. One is just that unemployment is very, very low, the labor market’s extremely tight, and inflation is very high.”

What’s causing the record-high inflation? And what’s next from the Fed? What are the odds of a recession? Here’s everything you need to know.

How bad is inflation right now?

In May, inflation surged to 8.6% over the previous year, reaching its highest level since December 1981, according to the Bureau of Labor Statistics. Gas prices rose 4.1% in May, bringing the increase in gas prices to 48.7% over the past 12 months. Food prices also increased by 1.2% in May, bringing that 12-month increase to 10.1% overall. 

During periods of high inflation, your dollar has less purchasing power, making everything you buy more expensive, even though you’re likely not getting paid more. In fact, more Americans are living paycheck to paycheck, and wages aren’t keeping up with inflation rates. 

What caused inflation to get so high this time?

In short, a lot of this can be attributed to the pandemic. In March 2020, the onset of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to close their doors and the global supply chain was abruptly put on pause. This caused the flow of goods produced and manufactured abroad and shipped to the US to cease for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for Economic Research.

But the reduction in supply was met with increased demand as Americans started purchasing durable goods to replace the services they used prior to the pandemic, said Josh Bivens, director of research at the Economic Policy Institute. “The pandemic put distortions on both the demand and supply side of the US economy,” Bivens said. 

Though the immediate impacts of COVID-19 on the US economy are easing, labor disruptions and supply-and-demand imbalances persist, including shortages in microchips, steel, equipment and other goods, causing ongoing slowdowns in manufacturing and construction. Unanticipated shocks to the global economy have made things worse — particularly subsequent COVID variants, lockdowns in China (which impacts the availability of goods in the US) and the war in Ukraine (which affects gas prices), according to the World Bank.

Powell confirmed the World Bank’s findings at the Fed’s June meeting, calling these external factors challenging because they are outside of the central bank’s control

In recent weeks, some lawmakers have accused corporations of seizing on inflation to increase prices more than necessary, a form of price gouging.

What does the Federal Reserve have to do with inflation?

With inflation hitting record highs, the Fed was under a great deal of pressure from policymakers and consumers to get the situation under control. One of the Fed’s primary objectives is to promote price stability and maintain inflation at a rate of 2%. 

By raising interest rates, the Fed aims to slow down the economy by making borrowing more expensive. In turn, consumers, investors and businesses pause on making investments and purchases with credit, which leads to reduced economic demand, theoretically reeling in prices and balancing the scales of supply and demand. 

The Fed raised the federal funds rate by a quarter of a percentage point in March, followed by a half of a percentage point in May and three-quarters of a percentage point in mid-June. The federal funds rate is the interest rate that banks charge each other for borrowing and lending. And there’s a trickle-down effect: When it costs banks more to borrow from one another, they offset it by raising rates on their consumer loan products. That’s how the Fed effectively drives up interest rates in the US economy. 

The federal funds rate now sits at a range of 1.5% to 1.75%. But the Fed thinks this needs to go up significantly to see progress on inflation, likely into the 3.5% to 4% range, according to Powell.

However, hiking interest rates can only reduce inflationary pressures so much, especially when the current factors are largely on the supply side — and are worldwide. A growing number of economists say that the situation is more complicated to get under control, and that the Fed’s monetary policy alone is not enough.

How would increased interest rates spark a recession?

We can’t yet determine how these policy moves will broadly impact prices and wages. But with another three rate hikes projected this year, there’s concern that the Fed will overreact by raising rates too aggressively, which could spark a more painful economic downturn or create a recession

The National Bureau of Economic Research, which meets in July and will officially determine if the US is in a recession, defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” That means a declining gross domestic product, or GDP, alongside diminishing production and retail sales, as well as shrinking incomes and lower employment. 

Pushing up rates too quickly might reduce consumer demand too much and unduly stifle economic growth, leading businesses to lay off workers or stop hiring. That would drive up unemployment, leading to another problem for the Fed, as it’s also tasked with maintaining maximum employment. 

In a general sense, inflation and unemployment have an inverse relationship. When more people are working, they have the means to spend, leading to an increase in demand and elevated prices. However, when inflation is low, joblessness tends to be higher. But with prices remaining sky-high, many investors are increasingly worried about a coming period of stagflation — the toxic combination of slow economic growth with high unemployment and inflation. 

What do rising interest rates mean for you?

For the past two years, interest rates had been at historic lows, partially because the Fed slashed rates in 2020 to keep the US economy afloat in the face of lockdowns. The Fed kept interest rates near zero, a move made only once before, during the financial crisis of 2008. 

For the average consumer, increased interest rates means buying a car or a home will get more expensive, since you’ll pay more in interest. Higher rates could make it more expensive to refinance your mortgage or student loans. Moreover, the Fed hikes will drive up interest rates on credit cards, meaning that your debt on outstanding balances will go up. 

Securities and crypto markets could also be negatively impacted by the Fed’s decisions to raise rates. When interest rates go up, money is more expensive to borrow, leading to less liquidity in both the crypto and stock markets. Investor psychology can also cause markets to slide, as cautious investors may move their money out of stocks or crypto into more conservative investments, such as government bonds.

On the flip side, rising interest rates could mean a slightly better return for your savings accounts. Interest rates on savings deposits are directly affected by the federal funds rate. Several banks have already increased annual percentage yields, or APYs, on their savings accounts and certificates of deposit in the wake of the Fed’s rate hikes.

We’ll keep you updated on the evolving economic situation as it develops.