The Effect of Rising Interest Rates on the Economy

By Chris Duderstadt

March 29, 2023

The Effect of Rising Interest Rates on the Economy

Key Points – The Effect of Rising Interest Rates on the Economy

  • The Fed Has Been Raising Rates for More Than a Year Now
  • How Long Does It Take to Feel the Effect of Rising Interest Rates?
  • Consumer Debt Is at an All-Time High
  • The Yield Curve Remains Steeply Inverted, Which Is a Strong Indicator of a Recession
  • 10 Minutes to Read | 23 Minutes to Listen

Another Increase of the Fed Funds Rate

In case you missed it, Federal Reserve Chairman Jerome Powell announced another 0.25% Fed funds rate hike on March 22. The Fed funds rate is now in the 4.75-5% range. So, where will interest rates go from here and what does that mean for you and your retirement plans? Dean Barber and Bud Kasper will discuss the effect of rising interest rates on the economy and much more on America’s Wealth Management Show.

A Year in Review to Outline the Effect of Rising Interest Rates

The Federal Reserve is back at it in March with raising interest rates. A lot of people thought that what’s going on with Silicon Valley Bank and other banks that the Fed would pause their interest rate hikes. That wasn’t the case.

Before we dive into describing the effect of rising interest rates on the economy and what could happen next, let’s look back at this time last year—specifically to March 17, 2022. It was the first increase of the Fed funds rate in this long series of rate hikes. Even in the fourth quarter of 2021, Bud was imploring the Fed to start raising rates sooner rather than later. Instead, the Fed waited.

Jerome Powell kept using the word transitory when talking about inflation. First, there was the initial 0.25% hike on March 17, 2022. Then, a 0.5% increase followed on May 5. After that, there were 0.75% hikes on June 16, July 27, September 21, and November 2. We finished 2022 with another 0.5% increase. And before this most recent hike, there was a 0.25% hike on February 1. That’s how the Fed funds rate range went from 0.25-0.5% to 4.75-5%. The effect of rising interest rates is starting to take hold.

“Here’s the problem I have with that. Depending on which economist you listen to, they’re going to say that it takes anywhere from six to 12 months before the effects of the first interest rate hike are felt in the economy. So, here we are a year later. I see signs of a slowing economy and layoffs, especially in the economy sector. That’s leaking into other sectors.” – Dean Barber

Are We in a Recession?

Almost 13% of the $1.4 trillion in automobile debt is now in default, which means it’s more than 90 past due. And that means that the cars can be repossessed. We’re going to see a ton of used cars hit the market, which should push the value of used cars back down to a reasonable level. That is one of many signs that’s pointing to a slowing economy. And Bud believes that we’re in a recession.

“I had hoped all along that it was going to be a mild recession and am still hoping for that. But when looking at what the Federal Reserve has done, it was too fast and too much. They could’ve slowed those rate increases so there would have been more 0.25% hikes instead of 0.75% hikes. They were trying to get ahead of it because inflation wasn’t dropping as fast as they wanted it to to get back to their 2% target.” – Bud Kasper

Bank Failures Are a Result of the Effect of Rising Interest Rates

We know that the substantial and swift effect of rising interest rates had a lot to do with the bank failures we’ve seen recently. The more conservatively run institutions are in better shape, but these rate hikes have taken a toll on many financial institutions.

The Fed’s Goal is to Kill Inflation

But if we think about the double-edged sword that the Federal Reserve is dealing with, they have two choices. They can kill inflation or they can kill the financial institutions. The Fed has made it clear that their goal is to kill inflation. So, the threat of a recession is extremely real. That being said, it’s important to stay calm and patient.

“I don’t want people to freak out because we’ve been through a lot of recessions. If you think about the economic cycles that we go through and think about a pendulum, that pendulum will swing to where you’re growing too fast and then it will swing to where you’re growing too slow. It never stops right in the middle so that it stays at that just-right level.” – Dean Barber

If the rate hikes take 12 months to take effect and assume that Jerome Powell has this crystal ball and knows that this last rate hike was the one that’s going to get the target inflation rate back to 2%. That means that we won’t see that target 2% inflation until Q1 or Q2 of 2024. We’re going to need to see some substantial slowing of the inflation rate for the balance of 2023 to feel confident that we’ll reach that target rate by then.

“Quite frankly, I don’t see that as a reality. If we reach 3% by then, I’ll be happy. We live in a very dangerous world right now. We keep piling debt on. I don’t think it’s ever been more challenging, and we’re not handling it. We know we have a debt ceiling deadline in September. If that issue isn’t solved by then, it could get a lot more volatile.” – Bud Kasper

What Kind of Debt Are We Dealing With?

The thing is that it’s not just government debt we’re dealing with. It’s consumer debt as well. Credit card, automobile, and consumer debt are at record highs. And we’re in a rising interest rate environment. The massive amount of consumer debt is really going to cause the slowdown the economy because the consumer is only spending money on the necessities.

“If consumer spending is 70% of our GDP, the Fed knows that they need to kill the consumer to slow the economy down. That’s exactly what they’re aiming to do.” – Dean Barber

Some Eye-Opening Moments in the Magical Kingdom

Bud has some pertinent facts to present about this issue after spending time with his family in Disney World and Universal Studios last week. It’s been a family tradition to go there for a family vacation, but this one felt a little different. Bud was quick to notice that the amusement parks weren’t nearly as packed as usual.

“It’s funny how people like us who are in the business can take a step back and say, ‘Is this even normal? Why am I getting on this ride as fast as I was able to?’ The reality is that this is showing the impact and it’s only going to get worse. If consumer debt is going up, the luxury of taking a family vacation is going to be difficult.” – Bud Kasper

Good Debt vs. Bad Debt

When Dean and Bud talk about this with their clients, they usually get asked, ‘Who carries that much debt?’ Our clients don’t carry that much debt. Most of them are debt-free or have a super-low interest rate on a mortgage or car. They understand that that’s good debt. That’s not bad debt.

But they’re not the average consumer. The average consumer lives paycheck to paycheck. So many people don’t even focus on saving. They’re just focused on the here and the now and will borrow for things. Consumer debt is going to start choking off the economy because the consumer can’t continue deficit spending. They can’t print money like the federal government can. That’s exactly what the government is doing and they’ll probably keep doing it.

The Inverted Yield Curve

Something else that has caught Bud and Dean’s eyes for the past few months has been the inverted yield curve. That means that the yields on short-term treasuries are higher than the yields on long-term treasuries. If you get an inversion where the yield on the two-year is higher than the yield on the 10-year that that leads to a recession.

“We have a six-month treasury at 4.87%. We have a 10-year treasury at 3.6%. So, a six-month treasury is giving you 1.2% more of a return than if you tie your money up for 10 years. That is a very steeply inverted yield curve. There’s no way in my opinion that a recession isn’t imminent.” – Dean Barber

Short-Term Treasuries vs. Long-Term Treasuries

The 10-year treasury has long been known as the risk-free return. If you go back to 2020, the yield on the 10-year treasury was 1.1%. That jumped up to as high as a little more than 4% prior to the failure of Silicon Valley Bank and Signature Bank. Now, we’re down to a little more than 3.5%.

Meanwhile, the six-month treasury was a little more than 5% before those bank failures. It’s still around 4.9%, so it hasn’t had as big of a drop as the 10-year treasury did. Dean says that it’s very important to be careful here.

“You need to understand that if we go into a recession, the opportunity will not be in those short-term treasuries. The opportunity will be in the longer-term treasuries. The longer-term treasuries got killed in 2022 with the rapid increase in interest rates, but they will do extremely well if we go into a recession and the Fed is forced to lower rates.” – Dean Barber

Keeping an Eye Out for Opportunities

In 2022, we saw around a 13% loss in bonds while the S&P 500 lost 19%. So, having a 4.5% return feels pretty good from that perspective. We knew part of the effect of rising interest rates was going to be trouble for traditional bonds. But now that we’re coming off the bond market’s worst year in 40 years, there’s opportunity to be had. When these prices are coming down, the yields are going up. While they’re not absent of volatility since the Federal Reserve is still raising rates, they’re becoming more attractive.

We do want to stress that we’re not trying to give investment advice here. Everything is still going to depend on your personal situation and overall asset allocation.

The Question Everyone Wants to Know the Answer to

We mentioned earlier about trying to look into a crystal ball to predict how many more hikes that the Federal Reserve will announce and what the effect of rising interest rates on the economy will be going forward. Unfortunately, we don’t have answers to those questions. But we can make educated guesses based on what we know. Here’s Bud’s educated guess when asked by Dean if he thought Powell would push the Fed funds rate to 6% or even higher to 7% or 7.5%.

“I don’t. I’m inclined to say that we might have another rate hike. Two isn’t out of the question. What they didn’t want is to create an image of them looking like they don’t know what they’re doing. Therefore, they’re tapering. They’re cutting back on the interest rate, as they should. A lot of people said they should’ve done it when the banking issue came up. I disagree. The Federal Reserve needs to look way beyond what’s happening now. As they move forward, they’ll need to take a more measured approach as to when they’re going to pause.” – Bud Kasper

Looking Back at the Dot-Com Bubble and Great Recession

The last time that the Fed funds rate was at 6% or higher was May 16, 2000. It was at 6.5%. That was when the Dot-Com Bubble burst. We ended up losing 46.5% in three years. We went from 6.5% on the Fed funds rate in early 2000 to 1.75% in December 2001. By June 2003, we got back down to a Fed funds rate of 1%.

Then, we had the Great Financial Crisis a few years later that also demonstrated the effect of rising interest rates. They never really got back to a normalized state after the Great Recession. Now is the first time since then that we’ve seen the Fed funds rate in the 4.5-5% range.

The Silver Lining in the Effect of Rising Interest Rates

If the Fed to raise rates too far and too fast to where we go into a recession, the question then becomes, how long, deep, and painful will it be? But there’s a silver lining here. If the Fed can slow the economy to a point where they can get inflation under control, the Fed will step out of the way and the markets won’t need to worry about the Fed fighting them. Suddenly, the Fed can be on our side again to help rev the economy back up.

“It’s the old saying, ‘Every bear market is followed by a bull market.’ That’s true in the bond and stock markets. People shouldn’t be running for the hills at this point to where they’re abandoning equities and bonds. While we don’t know when the bear market in bonds or stocks will end, we do know that it will. And we know that following that, there is significant upside potential. But when fear and greed take over, that’s when people start making emotional decisions instead of logical ones.” – Dean Barber

Your Probability of Success

The reason that people make those emotional decisions is because they lack the clarity of a comprehensive financial plan. That’s especially true for people that are in retirement. After losing money in the markets last year, how else are you going to know if you can continue spending the way that you want to? You need to determine your probability of success to know if you can withstand long-term negative periods in the markets.

If it took you from a 95% probability of success to a 93% or 92% probability of success, you don’t need to change anything. You keep doing what you’re doing because you know that you had the right asset allocation in the first place.

“When you understand the dynamics at play and take a step back and look at the bigger picture, you need to take the portfolio that you have today and stress test it through all different types of historical market cycles. You can then see the likely outcome, which gives you the clarity that you need to make intelligent and informed decisions as opposed to emotional decisions.” – Dean Barber

Do You Have a Comprehensive Financial Plan?

It all starts with creating a financial plan. We also have another resource that can help you with gauging your retirement readiness. It’s our Retirement Plan Checklist, which has 30 yes-or-no questions to assess your ability to comfortably retire and age-and date-based timelines of things to consider when preparing for retirement. Download your copy below!

Download: Retirement Plan Checklist

As we help people build their financial plans, they often ask us questions about whether they have enough money to achieve their retirement goals. For example, someone might ask that if they spend X-amount of dollars on a vacation or second house, how could that upend their probability of success in retirement? We can run those numbers within the financial plan to give you the clarity that you need in retirement.

Closing Points on the Effect of Rising Interest Rates

In conclusion, while we have had a Federal Reserve that has rapidly increased interest rates to fight inflation—therefore hurting the consumer—this isn’t a time to make emotional decisions with your investments. This is a time to step back and create a well thought out plan.

We can get you started with that, as we’re letting you use our financial planning tool from the comfort of your own home. This is the same tool that our CFP® Professionals use with our clients, so this is an opportunity for you to start creating a plan that unique to you at no cost or obligation. You can begin building your plan by clicking the “Start Planning” button below.


We Can Help with Building Your Plan

It’s also pivotal to work with a CFP® Professional that understands your overall objectives in retirement. That CFP® Professional will review your objectives and the assets that you have before designing a plan that gives you the highest probability of success to achieve your goals with taking on the least amount of risk possible.

If you have any questions about how that process works or specific about the effect of rising interest rates, we welcome the opportunity to answer them. You can schedule a meeting—whether it’s a 20-minute “ask anything” session or complimentary consultation—with one of our CFP® Professionals by clicking here. The setting of that meeting is totally up to you. It can be in person, virtually, or over the phone.

The Effect of Rising Interest Rates on the Economy | Watch Guide

Introduction: 00:00
Rate Hikes and the Current Economy: 00:58
The Threat of a Recession: 05:50
Bud Goes to Disney: 08:45
The Debt Issue: 09:45
The Inverted Yield Curve is STILL Here: 10:54
Will the Rate Hikes Continue?: 16:24
Conclusion: 22:05

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Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management, LLC, an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management, LLC does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.