Mar 3, 2017

When the Fed screws up, recessions follow

The Federal Reserve will decide in two weeks whether to raise interest rates for the second time in three months. Improving economic data like rising wages and inflation, and a soaring stock market, have prompted markets to assume they will do so.

Higher rates are a good sign at this stage of the recovery — they show that markets expect better economic conditions in the future. But this part of the business cycle also comes with risks, given the fact that as of this week we are in the midst of the third-longest economic expansion in modern history, after the booms between 1991 and 2001 and 1961 and 1969.

Good things must come to an end: Fed Chair Janet Yellen says that economic expansions "don't die of old age," rather, they have specific triggers, like central bank error or the build up of economic imbalances in the system. But every fiscal quarter is another roll of the dice — eventually it will come up snake eyes. The largest risk to the economy right now is the Federal Reserve's plan to raise rates over the next several years, as many recessions in the past have occurred after the Fed tightened policy in an attempt to rein in inflation.

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Data: Federal Reserve Bank of St. Louis, Board of Governors of the Federal Reserve System; Chart: Andrew Witherspoon / Axios
  • Early 80s: These two recessions were triggered by Fed Chair Paul Volcker's extreme interest-rate increases aimed at taming one of the worst bouts of inflation in modern American history.
  • Early 90s: Fed funds rates were also rising in the months leading up to the recession; but one can also argue the culprit was the runup in oil prices that resulted from the Gulf War, sapping spending power and consumer confidence.
  • Early aughts: The Federal Reserve began raising rates as the dot com bubble expanded during the late nineties, and raised rates steadily from the winter of 1999 through the fall of 2000 in an attempt to cool an overheating economy. By March 2001, the economy was in recession.
  • The Great Recession: The housing bubble was certainly a culprit of the 2008-2009 recession, but many blame the Federal Reserve as well. Bush Administration monetary economist Scott Sumner thinks the Fed should have moved much more quickly to lower interest rates in the months leading up to the recession, and could have possibly avoided the recession altogether if they had.

Rising interest rates are just one cause of recessions, but they are particularly potent because they act as break on all sectors simultaneously. By the summer of 2018, we'll be in the longest expansion ever. If Donald Trump can make it even one term without presiding over a downturn, it will be an unprecedented event.

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