May 23, 2023
The US Federal Reserve raised interest rates by 25 basis points on May 3, 2023, taking the cumulative tightening to 500 basis points. This has been the largest and fastest tightening cycle in the past 40 years, though we believe the rate hike in May will likely be the Fed’s last. The aggressive nature of the cumulative tightening is the primary driver of most recession calls, including our own.
The chart below illustrates the monetary tightening cycles that have occurred over the past 40 years, including those cycles that did not result in a recession (1983-1984, 1994-1995, and 2015-2018). Generally, the more aggressive tightening cycles tended to be followed by a recession, but not always. Where is the disconnect? We believe the answer lies in credit conditions.
A few months ago, we wrote about the severe tightening in bank lending standards that has taken place. While we only have data on bank lending standards going back to 1990, comparing that data to Fed tightening cycles is informative, in our view. During the tightening cycles that did not result in a recession, bank lending standards did not tighten in any significant fashion. In other words, higher interest rates did not result in banks restricting the availability of credit during those times.
The blue line shows how aggressive the Fed’s most recent tightening cycle has been. But what about credit conditions? Recent data suggests that lending standards have tightened further since the first signs of trouble in the banking system emerged with the collapse of Silicon Valley Bank in March 2023. As a result, banks have tightened lending standards even further. The transmission of aggressive rate hikes to tighter credit conditions leads us to continue to believe that a recession is likely in the coming months.
Change in the federal funds rate during monetary tightening cycles
Sources: Macquarie, Macrobond, Federal Reserve Bank of Dallas.
Note: Chart data depicts the magnitude and duration of Fed tightening cycles. Dashed lines shows those tightening cycles that did not result in a recession.
Chart is for illustrative purposes only.
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