The Federal Reserve uses monetary policy to dampen the highs and lows of business cycles. The primary tool the Fed uses is changes to short-term interest rates. When the economy experiences a recession, the Fed lowers interest rates to spur economic growth. When the economy is expanding strongly, they raise interest rates. Eventually, they raise rates too far and cause a recession. The Fed has now raised interest rates seven times during this business cycle. We examine past cycles to determine how much is too much.
Before we dive into the details, it’s important to understand the impact that the Federal Reserve has on the economy. There has never been a recession without the Fed first raising interest rates. The chart below shows the Federal Funds Rate between 1954 and 2018 and recessions (grey areas). Notice that prior to every recession, the Fed has raised rates.
Impact of Rising Rates
Many forms of debt are influenced by the Federal Funds rates. The interest that consumers pay on credit cards, auto loans, student debt and others, are all influenced by changes to the Federal Funds Rate. For businesses, their lines of credit are often adjustable and tied to short-term interest rates. So when the Fed raises interest rates, they are effectively raising the borrowing costs for consumers and businesses.
As the Fed continues to raise interest rates, eventually, the economy begins to slow. In the table below, we examine the last nine business cycles to see just how far rates can rise before a recession occurs. Excluding the current cycle, the average number of 0.25% increases was 23. However, during the 1950’s interests rates were low much like they are today. Those two cycles ended with just far fewer interest rate increases. This suggests that the average of all cycles may not apply this time around.
How High Can Rates Go?
Another aspect worth looking at is the difference between the Fed Funds Rate and longer term interest rates. This is important because it is a way of measuring the profitability of lending. The Fed Funds Rate is the interest rate that banks charge each other to borrow money overnight. So if a bank needs money to balance their books, they can borrow it from another bank.
Here is an example: Today the Fed Funds Rate is 1.9%. Let’s say a large bank needs a billion dollars to balance their books. Through the Fed, they can borrow that money from another bank and pay an annual rate of 1.9%, but for just a day. The daily interest they would pay is roughly $6,850. This is no big deal for a big banks; they are dealing with tens of billions of dollars every day.
Here is where this can become a problem. If a bank has to pay 1.9% to get the capital is needs to operate, it has to generate more than 1.9% to make a profit. Banks are in the business of making loans. They borrow money from depositors and/or other banks at short term interest rates and lend it out at longer term interest rates. So long as long-term interest rates are higher than short-term rates, they can make a profit. However, sometimes short-term rates are higher than long-term rates. This typically happens because the Fed has raised short-term rates too far.
Below is a table of with each of the last nine business cycles. Here we show the difference between the Fed Funds Rate (short-term) and the 10-Year Treasury (long-term). In each instance, the difference between short-term rates and long-term rates is either negative or very close to negative. Meaning that banks have to pay more to get capital than they can earn by lending it out.
The chart below shows the difference between Fed Funds and the 10-Year Treasury going back to 1954. Near the end of each business cycle, the Federal Funds Rate gets very close to, or surpasses, the rate on the 10-year treasury bond.
The Fed is expected to raise interest rates two more times in 2018. They are also expected to raise rates three times during the course of 2019. If they do go through with their plan, the Fed Funds Rate would be between 3% and 3.25%. With the 10-year Treasury currently at 2.9%, they may risk pushing short-term rates above long-term rates. A phenomenon known as an “Inverted Yield Curve”. The environment for banks will become challenging as their primary business of lending would become less profitable. Eventually, banks will reduce lending and the economy will likely fall into a recession.
The number to watch is the yield on the 10-year treasury. If it rises as the Fed raises rates, this business cycle will continue to have legs. If however, the 10-year yield does not rise, investors will need to be prepared.
Our Business Cycle Indicator is designed to provide a warning prior to a recession in the US economy.