The Federal Reserve, as expected, yesterday raised overnight target interest rates to between 1.5% and 1.75% in new Federal Reserve Chairman Jay Powell’s first major act at the helm. With interest rates still at historic lows, notwithstanding the substantial rise in Treasury yields across the curve since September, how many more increases can the economy withstand before going into recession?
While yesterday’s rate hike may not crash the economy, at some point, a future rate hike will. The question is, when? Let’s take a look and see if we can come up with at least a range.
First, it is important to understand how the Fed tinkers with rates in the first place. Mainstream financial news media’s general lack of description as to how the Fed raises rates leaves most with the implicit assumption that they do so simply by saying it, as if by magic or law. Many believe the Federal Open Market Committee declares what the overnight rate will be and because Fed member banks must follow its regulations generally speaking, therefore they must then borrow from and loan to one another at the new rate by regulation.
That is simply not the case. Instead, the FOMC enters the market, hence the “Open Market” part of its name, and either buys securities from or sells securities to banks in order to change the amount of reserves they hold, which indirectly affects the interest rate at which they are loaned overnight from bank to bank.
That’s why the overnight rate is called the federal funds target rate, because it is a target range the Fed is setting by altering reserve volumes, not a regulation that member banks must follow by law.
The key is, in order to raise the overnight target rate, the Fed has to lower the amount of dollars available in the banking system, making liquidity more expensive and, therefore, rates higher. When selling securities to its member banks, the Fed takes the money raised through these sales and retires it. It just goes out of circulation.
This is not a problem so long as banks can keep creating money by loaning and profiting off of yield spreads. As long as the yield curve is positive to any degree, even a small one, money creation through interbank loans can overcome the “money suction” initiated by the Fed when it raises the overnight target rate.
It usually doesn’t matter how positive the spread is between long and short, only that it is positive. Why not? Because it doesn’t matter how much any individual bank profits off of any given loan. That’s prioritizing pennies over dollars. What matters is that loans are made and that through the loan cycle, more dollars are available as a result to make more investments in order to keep the boom going.
As you can see from the two charts below, the volume of bank loans to the private sector depends on the steepness of the yield curve. While there is some lag, when it turns negative, loan volume starts decreasing soon afterward, with recession soon following.
The 10-year and and two-year yield spreads are currently still positive, but barely, so the Fed still has room to run with interest rate hikes before it runs the economy into recession. How many rate hikes it has left largely depends on the long end of the curve. If 10-year rates continue to rise, the spread will stay positive and the Fed can keep moving the overnight target rate higher. But if the long end of the curve stays flat while the short end rises, there won’t be much more room to run.
In the chart above, we can see the 10-year line. While it does generally follow the two-year and overnight rates, it does wobble more independently of the other two. Meaning, the short end is much more dependent on the overnight rate than the long end. How it will wobble this time is anyone’s guess, but if it doesn’t wobble higher, and with the 10-year and two-year spreads only at 0.55, there may only be two to three more rate hikes before we hit the next recession.
