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Around the world, many people are wondering about the possibility of recession. Here in the US, there are some warning signs that a recession may be close.
The general definition of a recession is when there is two quarters of negative GDP consecutively. By this definition, the U.S entered a recession in summer 2022. However, in quarter three and quarter four of 2022, there was economic growth. This means that the US is not currently in a recession.
Why We Think Interest Rates Will Stay High
A key factor in whether we will enter a recession is the interest rate. The current pattern of interest rates in the US are on an upward trend. Interest rates bottomed out in the aftermath of the 2007 financial crisis, but since 2015, rates have been steadily increasing, with the current rate almost matching the peak 2006 rates.
The main reason for these increasing interest rates is the correlation between interest rate and inflation. This is often referred to as inflation pace. Simply put, inflation is a reflection of the cost of living. When the price of goods and services change, it is measured in the rate of inflation. This measurement provides a percentage to reflect how prices are changing in the economy.
Most of us are aware that the prices of food and energy have increased over the last year or so, but the core inflation rate, which is the level of price increases minus food and energy, has also increased. The federal government cannot allow prices to continue skyward, so the FED implements changes to the interest rate to address this. As interest rates increase, it slows down or halts the increasing inflation.
Since the rate of inflation has not been slowed significantly, it is likely that the FED will continue to increase the base interest rate, which is why consumer interest rates are likely to stay high.
The Inevitable Effect of High Interest Rates
On February 1, 2023, the FED increased the benchmark interest rate a further quarter percent, which is the eighth increase since March 2022. This has already created massive change in the market and it is set to continue over the coming months.
There are a number of inevitable effects of continued high interest rates.
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The Real Estate Market
The first is on the real estate market. When interest rates are high, there is more hesitancy from buyers. Those who already own a home are less likely to want to upgrade to a larger home as they will need to manage increasing mortgage costs. The higher interest rates can be particularly hard hitting for those coming to the end of a fixed rate home loan deal, as they can find themselves suddenly facing a significantly higher monthly mortgage bill.
The higher rates can also affect those looking to enter the housing market. New homebuyers are likely to have greater difficulty accessing a home loan, and may take a wait and see approach to see if interest rates will start to fall. Both of these scenarios tend to lead to the real estate market starting to stall.
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Personal Debt
High interest rates also have a massive impact on personal debt. With the exception of fixed rate personal loans, most personal debt has a variable rate. This means that when the interest rates increase, the cost of borrowing also increases.
So, the cost of your credit card debt and other debt obligations are likely to cost more to service each month. This can lead to more consumers struggling with debt and having issues with credit for years to come.
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Early Stage Businesses
If you’re looking to get a business off the ground or you have a business in its infancy, the higher interest rates can have a massive impact on financing costs.
When rates are higher, it can be more difficult to secure financing, as the cost of servicing the debt will be higher. Banks and other lenders are likely to have more stringent requirements to qualify for financing, which can create a barrier to entry for many fledgling companies.
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US Bond Rates & The Stock Market
High interest rates tend to drive investors towards US Bonds, as they offer more competitive yields compared to the potential future earnings from stocks.
Additionally, newbie investors are also more likely to shy away from the stock market, as they can lock in the higher rates with deposit products such as CDs without the risk of the stock market.
Of course, savvy investors will continue to use the stock market to access inflation resistant commodities like gold, but are likely to still view bonds as an attractive option.
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Unemployment Rates
Another implication of high interest rates is a rise in the rate of unemployment.
As higher interest rates increase the costs of doing business, employers aim to try to cut costs to remain competitive. This can lead to layoffs and higher rates of unemployment.
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Black Swan Risk
While the points we have discussed are pertinent, there is also a black swan risk of a recession. There are geopolitical conditions and new financial challenges, which can have a direct impact on the economy. We have already felt the impact of the Russia Ukraine war within our economy, and if this conflict continues, the effects are likely to be more dramatic.
We’ve already covered that being involved in a war increases government spending, but it also creates problems with supply chains, which can drive prices higher. There is also a feeling of uncertainty, which can stall consumer spending, who are waiting to see if they should hold on to their money. There is also potential harm from the threat of further conflicts, such as between China and Taiwan or Israel and Iran.
We also cannot predict any unknown financial challenges that we could face in the near future. For example, if countries around the world head into bankruptcy, it can create a ripple effect on global economies.
Why Don’t We See Effects Now?
You may wonder if this is all speculation and why we are not seeing effects right now. The simple answer is that businesses don’t tend to fail quickly. Large businesses have greater resistance to recession conditions, which can create a false sense of security. At the moment, businesses and start ups have managed to raise a lot of money, which could allow them to weather any financial storm for a while.
The real estate prices appear to be quite stable at the moment, but there is a belief that people will aim to do anything but sell their house. Consumers who are struggling with the rising costs may take on gig work to generate additional income and those who are living in a smaller home may try to make the situation work with a small renovation. This means that there hasn’t been a massive drop in demand, which has allowed the real estate market to remain fairly stable.
In the stock market, it is just 15% from an all time high, but with 15 years of stock increases, changing a paradigm will take time. So, while we may not see any noticeable change now, it could still appear in the future.
Summary: Are We Getting Closer To A Recession?
We believe that a recession is close, but when it will hit the economy will depend on changes in government policy, inflation, interest rates and situations around the world. But, don’t simply wait for a recession to hit. Now is the time to take proactive action and get your finances under control.
With the threat of a recession, it is a good time to try to pay down debt, consider what you will do with excess funds and ensure that you have secured the best rates for any borrowing. This should provide some buffer, so you can weather a financial storm as and when it hits.
