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How Could Higher Interest Rates Cause a Recession?

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Interest rates are top of mind for many economists as illustrated in a new poll predicting a 75-basis-point rate hike in July. While…

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Interest rates are top of mind for many economists as illustrated in a new poll predicting a 75-basis-point rate hike in July. While some are pleased with the Federal Reserve’s commitment to lowering rampant inflation, others are concerned about the wider effects of tighter monetary policy. Could higher interest rates cause a recession?

According to some analysts, maybe. The logic behind raising interest rates is pretty clear. Higher rates discourage borrowing, which lowers the supply of cash in the economy, which should, holding everything else equal, lower the overall price level.

The question that remains for interest rates is how high is too high? Should the Fed raise rates too high too quickly, inflation won’t go down without consequence. Higher interest rates will lower the total demand for goods in the economy, which as mentioned, will lower inflation. However, as a result of the lower aggregate demand, companies will likely have to lay off employees to account for lower revenue uptake. Unemployment may rise dramatically in response to higher interest rates.

In recent days, former Treasury Secretary Larry Summers stated the U.S. needs “five years of unemployment above 5% to contain inflation.” Summers elaborated that “we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment.” These are recessionary levels of unemployment, and imply that more than 10 million Americans would need to be laid off.

How Could Higher Interest Rates Cause a Recession?

Interest rates, inflation and unemployment all operate in conjunction with each other. It’s difficult to manipulate one variable in your favor without affecting the other two. Fed Chair Jerome Powell has repeatedly said that the central bank is “unconditional” in its commitment to lowering inflation. The Fed is likely prepared to enter a minor recession in order to do so.

Interest rates are the Fed’s most dynamic and important monetary tool. While Powell has frequently raised hopes for a soft landing, inflation has been uniquely stubborn this year. Even after the first several rounds of interest rate hikes, prices still haven’t eased.

Last month’s Consumer Price Index report painted a troubling picture for price levels in the country. Prices increased 8.6% this May compared with last year, jumping 1% from April.

The report comes as a sign the Fed will likely continue with its brutal interest rate hikes next month. A recent Reuters poll found three-quarters of economists expect a 75-basis-points hike in July. A majority of economists predict the Fed will hike rates an additional 50 basis points in September.

Americans everywhere will continue to monitor the Fed’s actions closely as the central bank attempts to ease inflation without spiraling the economy into a recession.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

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