Why aren’t high interest rates causing a recession in the US?

Later this afternoon, the Federal Reserve will announce possible changes to interest rates, which remain at the highest levels in recent memory. The Fed controls the federal funds rate (FFR), a baseline rate tacked onto loans distributed to individuals and businesses. As the US central bank, the Fed is the lender of last resort, meaning that the central bank must set a monetary policy that reduces the risk of widespread default. The FFR reduces the risk that lenders create hazardous loans.

For example, in times of great economic uncertainty, like that experienced by the United States in the aftermath of the COVID-19 economic turmoil, the Fed increased rates. This was done, in part, to bring down inflation by raising the price of lending and thus slowing the transfer of money through the economy.

Whether or not an economy is in a recession is typically evaluated by GDP growth. If the figure is negative for two consecutive quarters, the economy will be in a recession. According to the US Bureau of Economic Analysis, which tracks this indicator found that in the last two quarters of 2023, real GDP grew 8.1 percent.

Monetary policy and the risk of recession

Monetary policy is one way to avoid a recession (or create one if it is excessively tight in an environment that cannot tolerate such high or low-interest rates). The Federal Reserve will announce any changes to monetary policy this afternoon.

In early 2022, when inflation was surging, the FOMC began to impose rate hikes to cool the economy by increasing the cost of borrowing and thus slowing the movement of money. The Fed was concerned that high inflation could lead to an economic crisis if businesses could not keep up with costs and began to lay off workers. A rapid surge in unemployed workers could lead to decreased consumer spending, creating a vicious cycle where more workers are laid off, and aggregate demand would fall even further.

Some economists raised concerns that when the Fed began to increase interest rates, their actions would send the economy into a recession. Interestingly enough, increasing interest rates can also lead to increases in unemployment, leading to the same effect that the Fed was trying to avoid by raising rates to quell inflation. And, though recent GDP figures indicate that the economy is growing and not falling into a recession, even the Fed has warned that monetary policy has a lagging effect and the full extent of the impact that rate hikes have had may not be seen until the end of 2024 or early 2025. For that reason, the FOMC has been cautious when evaluating whether further rate increases are needed and, so far this year, has opted for more of a wait-and-see approach.