Why Rising Interest Rates Won't Push The US Economy Into A Recession

In its regular June meeting last week, the Fed sent a clear and loud message to markets: Fighting inflation isn't done. Interest rate hikes will continue for the rest of the year until inflation reaches the official goal of 2%.

Interest rate hikes are usually bad news for the economy and financial markets. They take their toll on aggregate demand and lead to a recession, which hurts corporate earnings and drives the shares of publicly traded companies lower.

Still, interest rate hiking cycles are different due to the context—the conditions and circumstances—meaning that there are exemptions to the rule.

Sometimes, interest rate hikes take place when the economy faces several tailwinds. Thus, it can withstand their negative impact heading to a soft landing rather than an outright recession, as is the case in the current situation.

First, despite several interest rate hikes, the U.S. economy continues to create new jobs, with unemployment hovering near multi-year lows.

"Robust payrolls and rising prime-age labor force participation underscore the labor market's health while moderating wages and marginal rises in unemployment portend a graceful landing," the June Bayard Brief said.

A healthy labor market has helped boost household income, and consumer spending remains robust. For instance, in April 2023, personal income rose by a monthly rate of 0.4%, up from a 0.3% rise in March — the highest gain in three months. In addition, consumer spending grew by 3.8% in the first quarter of 2023, up from a 1% increase in the previous period.

"The labor market has weathered elevated inflation, interest rate hikes and a surprisingly quick pandemic recovery thus far — but, faced with a looming storm of economic uncertainty, further slowing is likely," the June Bayard Brief continued.

Second, interest rate hikes have yet to cause a severe correction in home prices. In addition, equity markets have staged a remarkable comeback in recent months. As a result, households have been preserving or even expanding wealth, a positive factor for future consumer spending.

Third, inflation has dropped from around 9% a year ago to below 5% in recent months, another positive development for future consumer spending.

Fourth, the rapid spread of Artificial Intelligence (AI) systems keeps wage growth tamed. In addition, it helps boost productivity, which could put the economy into a virtuous cycle of supply-side growth. That's growth associated with lower inflation and lower unemployment.

"AI will prove deflationary only toward the end of the decade," Yohay Elam, senior financial analyst at fxstreet.com, told International Business Times. "Massive technological breakthroughs take time to impact the economy, and examples of what AI can do — impressive as they may seem — will take time to reap productivity benefits and job destruction that some expect. The Federal Reserve will likely keep interest rates high until hard evidence for economic softness appears — core inflation below 4% or unemployment above 5%."

Still, not everyone sees things that way. Scott Wren of Wells Fargo is one of them. During an interview with CNBC last Tuesday, he expressed that a recession is around the corner and that investors are in for a "bumpy ride."

Dutch Mendenhall, founder of RAD Diversified REIT, sees U.S. financial markets remaining even until the Fed is done with interest rate hikes. "As soon as the Fed stops raising interest rates, you'll see banks starting to free up capital," he told IBT. "As banks free up capital, you will see more money in the market. More money in the market will begin to reenergize the economy."