The Fed, Market Interest Rates, and the Coming Recession

The Fed is in a quandry these days. They were having a perfectly nice day raising interest rates as it seemed the economy was strong enough to tolerate higher rates. In early 2016, the Federal Funds Rate (FFR) was near zero so what harm could it do to move that rate a smidgen? The red line in the graph below shows the FFR and you can see how the Fed raised it through 2018. It reached a little above 2.25%, not particularly high by national standards. So why not keep raising the rate to maybe 3% or 4%?

Note: The FFR is usually considered an instrument of the monetary policy controlled by the Fed. But the FFR is connected through markets to the interest rates on lots of other assets so when the FFR goes up, it usually drags up many of those other rates. In that way, the Fed influences a broad spectrum of interest rates. Among those assets are Treasury bonds with a maturity of 10 years. The interest rate or yield on the 10-year Treasury is often taken as a gauge of all market interest rates. When the FFR is higher than the 10-year Treasury rate, we call this unusual situation an inversion. End of note.

The graph below explains the hesitancy to raise rates further. Consider the far left side of the graph. Notice the FFR hit the range of 6.5%. Notice also that the FFR rose well above a key market interest rate -- the return on a 10-year government bond. Finally, notice that a recession, as indicated by the grey shaded area, following this inversion of rates.

Move ahead to the time period after 2006 and you see another similar rise in the FFR and an inversion of the FFR rate above the 10-year yield. Bam!, another recession. In this case the FFR maxed out at a little over 5%, and that was quite an increase from the 1% rate that prevailed before the policy to raise the FFR.

Just looking back over the last 20 years or so, we come away with the idea that large increases in the FFR that result in the FFR being higher than the 10-year Treasury rate can lead to recessions. Now we see what looks like the same phenomenon happening again. We see the FFR rising after 2016. We also see we haven't had a recession for quite a while. And we see the 10-year rate starting to fall. There is no real inversion yet but if you extrapolate the lines, you might see one soon. If you looked up these rates on Friday June 14, the FFR range was 2.25% to 2.5% and the 10-year yield was 2.0%. That looks like an inversion to me.

So where is the recession? The answer is that the recession is hiding somewhere near my last glass of JD. Where did I put that thing? Or maybe the inversion-thing is not as reliable as the graph indicates?After all, recessions have always been pretty hard to predict. Maybe there is more to it?

Can the graph help? For one thing, at 2.25%, the FFR is not nearly as high as the 5-6% levels that preceded the last two recessions. For another thing, with the market rate at 2.1%, that is much lower than the 10-year Treasury rates prior to the last two recessions. And rates today have shown no real discernible rise. Rates have bobbled around since 2012, and the market rate today is no higher than a lot of dates since 2012 and certainly not much higher than the rest of the months since 2012. If you compare today's market rates to those before 2012, today's rates look modest.

Just looking at the FFR and a key market interest rate, therefore, does not necessarily proclaim the coming of the next recession. Of course, recessions have never been easy to understand or predict. A housing crisis had a lot to do with the last one and in the past, all sorts of things from oil price shocks  to anchovies dying have precipitated recessions. Today has no shortage of risky trends that could set off the next one. Whether Fed policy can or could set off the next one is no sure thing. Maybe they should just stick with their plan to raise rates to normal levels?