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How could higher interest rates cause a recession?


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Interest rates are a priority for many economists, as illustrated by a new survey forecasting a rate hike of 75 basis points in July. While some are pleased with the Federal Reserve’s commitment to reducing runaway inflation, others worry about the broader 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 reduces the supply of liquidity in the economy, which should, all else being equal, lower the general price level.

The question that remains for interest rates is how high is too high? If the Fed raises its rates too high too quickly, inflation will not fall without consequence. Higher interest rates will reduce the total demand for goods in the economy, which as mentioned will reduce inflation. However, due to lower aggregate demand, companies will likely have to lay off employees to accommodate lower revenue absorption. Unemployment can rise dramatically in response to higher interest rates.

In recent days, former Treasury Secretary Larry Summers said the United States needed “five years of unemployment above 5% to contain inflation.” Summers clarified that “we need two years of unemployment at 7.5% or five years of unemployment at 6% or one year of unemployment at 10%. These are recessive levels of unemployment and imply that more than 10 million Americans should be laid off.

How could higher interest rates cause a recession?

Interest rates, inflation and unemployment all work in conjunction with each other. It’s hard to manipulate one variable in your favor without affecting the other two. Fed Chairman Jerome Powell has repeatedly said the central bank is “unconditional” in its commitment to lower inflation. The Fed is likely ready to enter a minor recession to do this.

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

Last month’s Consumer Price Index report painted a troubling picture of price levels in the country. Prices rose 8.6% in May from a year ago, jumping 1% from April.

The report comes as a sign that the Fed is likely to continue its sharp interest rate hikes next month. A recent Reuters poll found that three-quarters of economists expect a 75 basis point hike in July. A majority of economists predict that the Fed will raise rates another 50 basis points in September.

Americans everywhere will continue to watch the Fed’s actions closely as the central bank attempts to reduce inflation without dragging the economy into a recession.

As of the date of publication, Shrey Dua did not hold (either directly or indirectly) any position in the securities mentioned in this article. The opinions expressed in this article are those of the author, subject to InvestorPlace.com publishing guidelines.

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