Fed Rate Hikes and Economic Hard Landings

The Federal Open Market Committee (FOMC) hiked its target federal funds rate by 75 basis points (bps) yesterday. This second consecutive triple-quarter-point (0.75%) rate hike was widely expected. A 50-basis-point rate hike is currently expected to be announced at the September meeting, according to the CME’s FedWatch tool.

A bigger question than the magnitude of future monetary policy actions is what effect this tightening cycle will have on the economy. Rate hikes have a delayed impact from the time they are made, but they do contribute to economic slowdowns—which is what they are designed to do.

Slower economic growth lessens inflationary pressure by reducing demand for goods and services. Ideally, the Federal Reserve will be able to slow economic growth just enough to bring down inflation but not send the economy into a recession. This scenario is the so-called soft landing.

Unfortunately, most prior rate-hike cycles have been followed by recessions, so-called hard landings. This week’s chart—from FRED, the St. Louis Federal Reserve’s economic database—shows this. The shaded columns are periods when recessions have occurred. The time span and the annotations chosen are based on a February 2022 presentation by economist and former Federal Reserve vice chairman Alan Blinder.

Only one of the 11 previous rate tightening cycles has resulted in what Blinder described as a “perfect soft landing.” This was the 310-basis-point tightening cycle that occurred between December 1993 and April 1995. Gross domestic product (GDP), according to Blinder, slowed from about 4.5% to 1.3% before rebounding.

The Fed did raise rates by a similar amount, 315 bps, in 1983 and 1984 without much impact on the economy. Whether it counts as a tightening cycle is up to debate. Blinder, for his part, described it as a “readjustment.”

The other nine rate-hike cycles were followed by so-called hard landings. If we set aside the coronavirus shutdown of 2020, there were only two periods where the landing was hard enough for the economy to contract by more than 2.5% on a real (inflation-adjusted) basis.

Real GDP contracted by 2.7% following the 1972–1974 rate-hike cycle. Interest rates were raised by 960 bps over that period. There had also been a sharp rise in food prices, the oil embargo by the Organization of the Petroleum Exporting Countries (OPEC), President Richard Nixon’s price controls and the Fed’s slowness in responding to rising inflation at the time.

During the Great Recession of 2007–2009, real GDP plunged by 3.8%. The severe economic downturn was preceded by the June 2004–June 2006 rate-hike cycle. Interest rates had been raised by 425 bps during that tightening cycle. There were also record high oil prices that preceded the recession. The bursting of the housing bubble and the coincident near collapse of the financial system intensified the severity of the downturn.

Six rate tightening cycles were followed by contractions of 2.2% (the 1977–1980 tightening cycle) or less. The 1965–1966 rate tightening cycle was followed by a period with real GDP remaining essentially unchanged, though Blinder says there was “a slowdown in 1966.” To the extent these are “less hard” landings or “not so hard” landings is a debate I’ll leave to the economists. They certainly felt like hard landings to anyone who lost a job or incurred other financial difficulties during those contractions.

Even if we set aside the discussion about hard versus soft landings, the lack of a clear correlation between the cumulative amount that interest rates were raised and the severity of the economic contraction that followed is worth noting. The Fed raised rates by 540 bps between 1967 and 1969 but real GDP fell by just 0.6%. The 425-basis-point rate hike in the mid-2000s was followed by a 3.8% contraction, as previously noted.

The FOMC has raised rates by a cumulative 225 bps during this tightening cycle, so far. There are signs of a slowing economy—rising initial jobless claims, a weakening housing market, a worsening index of leading indicators, the –0.9% decline in second-quarter GDP, etc.—but it’s still early. The best forecasters in the world cannot accurately predict whether the Fed will pull off a soft landing, a not-so-hard landing or a truly hard landing. It is a story that remains to be told.