The below chart is useful for thinking about interest rates and recessions. Both lines are annual averages for each year. The chart goes from 1953 to 2017. The blue line is the interest rate set by the Fed. It is called the Federal Funds Rate but we can call him FFR. The red line is the rate on 10 year Treasury Bonds. Let's call that one 10TB. 10TB is usually on top of FFR but please no sexual jokes. The FFR is below most interest rates since it is known to be a measure of the cost of funds for banks and other financial institutions. These institutions lend money at a rate above FFR so as to make profits. Being a floor rate -- when the Fed raises the FFR we expect most other rates to rise too. A rising tide lifts all boats or something like that.
As the chart below shows the Fed has raised the FFR, depending on how you count them, about 12 times over those 65 years. You can also see there are 9 vertical grey bars in the chart indicating recession years.In the case of every one of those recessions you can see that they were preceded by a rise in the FFR. But notice too that this FFR/Recession relationship is less like Fred and Ethel and more like Ricky and Lucy. That is, the relationship is highly unstable.
It took a huge increase in the FFR from 1976 to 1980 (and then to 1982) to cause two recessions. The FFR went from 5% to more than 15% -- a tripling -- to create those two recessions.
The 1990 recession was preceded by a rise in the FFR from 6.7% to 9.2% from 1987 to 1989. Strangely the FFR was already starting to fall before the recession hit.
The next recession didn't start until 2001 and while the FFR doubled from about 3% to 6.2%, it took from 1993 to 2000 to increase that much. Like the recession in 1990, this one didn't last very long.
The big recession of 2008/2009 looks peculiar. The FFR rose from 1.4% in 2004 to 5% in 2007 but then fell to 1.9% right before the recession. So we have four years of FFR action before that recession. But how much the FFR had to do with that recession depends on whether you use the 5% rate in 2007 or the 1.9% rate in 2008. And, of course, that recession had a lot to do with bad housing loans and less to do with FFR policy.
Some people seem to have a lot of clarity on their favorite bourbon as well as the impact of the FFR on the economy. I don't see it myself. While I love JD I also realize there are a lot of very interesting bourbons out there. And when it comes to the Fed lifting rates in 2018, I am not highly confident that such policy actions will lead to the economy or the stock market crashing.
A note on interest rates. This graph is very interesting. Notice the strong upward trend in interest rates before 1981 and the following 37 year downward trend. Much of that has to do with inflation. It makes sense that interest rates should be impacted by inflation. If you expect a rise in the inflation rate, investors demand a higher market interest rate -- because they know that inflation reduces the buying power of the future interest and principle payments they will receive. Just as coal miners wanted a 39% pay increase in 1979 (for a three-year contract) to shield them from high expected future inflation, financial market investors want higher returns.
Thus inflation and inflation expectations distort the graph. But for my purposes today, working with market rates creates no real distortions. The FFR is always quoted in nominal terms and the question here concerns whether policies that raise the FFR have a reliable relationship with dire changes in the overall economy. My answer is no.
One caveat. Caveat is a foreign word for cover my butt. Should the Fed raise the FFR a lot more and should they sustain that policy for a couple of years, then I'd start selling my bitcoins and Apple stock.