Why Interest Rates Don’t Need To Rise Much To Cause Recessions Now

As the probability of a U.S. recession in the next year grows rapidly (it may be as high as 64%), many bullish economists and financial commentators are unsurprisingly downplaying this risk.

  • Jesse Colombo

One of their main arguments is that interest rates have not been hiked aggressively enough to tip the economy over into a recession. While it is true that U.S. interest rates are still very low by historic standards, the reality is that rates do not have to rise anywhere near as high as they did in the past to cause recessions due to America’s debt load that has grown dramatically over the past several decades.

Since the early-1980s, total U.S. debt – both public and private – has been growing at a faster rate than the underlying economy, as measured by the nominal GDP:

As a result of debt growing faster than our underlying economy, America’s debt as a percent of GDP soared from just over 150% in the early-1980s to approximately 350% in recent years. This higher debt burden is the reason why our economy simply cannot handle interest rates as high as they were before 2008. …

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As the Fed Funds rate chart below shows, the interest rate threshold necessary to trigger recessions (recessions are designated by the gray bars) keeps falling as our debt burden increases:

Though many optimists are quick to point out that the benchmark Fed Funds rate was only increased from 0% to 2.5% during the current tightening cycle, the reality is that the current tightening cycle is even more aggressive than the past several cycles when the Fed Funds rate is adjusted for quantitative easing (this is known as the shadow Fed Funds rate – learn more). According to this methodology, interest rates have increased by the equivalent of 5.41% in the current cycle versus just 3.62% before the 2001 recession and 4.26% before the Great Recession of 2007 to 2009: …

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