The Fed-Fund rates have been near zero for five years, along with the central bank implementing QE to the tune of over $4 trillion dollars (so far). The QE process looks likely to end in October 2014, when the Federal Reserve meets to reduce the final $15bn of money printing. After that, market commentators are pencilling in the first rate hike in Mid-2015.
But, the question is if interest rates do go up, how far will they go up, and by how much before we face our next recession?
Looking back at memory lane on the history of Federal Reserves Fed-Fund rates (as shown by two charts).
Chart 1: This is a chart showing the Fed-Fund rates since 1950s:
Chart 2: Show U.S. economy in recession in different periods:
Ever since that record high in late 1970s, the peak in interest rate is lower than the previous peaks and the cuts in interest rates have been more drastic than the last to fight the recession.
One would speculate in chart 1, the next peak depending on when and how fast the Federal Reserve’s raises Fed Rates, could be as high as 2.25%, or as low as 1.5%, before the next recession would ensue.
The above logic is assuming one particular factor: ‘IF inflation rate won’t go too high.’
Chart 3: - Shows U.S. inflation rate since 1950s:
By comparing chart 1 and chart 3, there is a similar correlation. The rule here is: ‘Higher inflation rates equal higher interest rates.’
I shouldn’t say that economic growth has no correlation with inflation rates that is just not true. However, in a situation where the economy is experiencing a supply issue, this will be true. What I mean by that is if supply is slow to catch up with demand, prices will rise.
That has caused GDP to drop in the US, because they’re not the main benefactor of higher oil prices. In 1973-74, OPEC countries decided to cut oil production, and were compensated by the rise in oil prices of between $3 and $12 per barrel. Simultaneously, the U.S. inflation rate spiked from 3% to 12% in two years, before falling to 5% in 1976. The second spike in inflation was due to the panic of oil production in Iran, due to a revolution.
So when supply isn’t an issue then inflation rates have no-bearing to whether an economy would enter recession or not.
Right now, the inflation rate is below 2% in the U.S. and most commodities prices already peaking, I would say a rise in interest rate to between 1.5 % and 2.25% would be followed by the next recession.