During the Federal Reserve policy meeting on Wednesday, Chair Jerome Powell signaled that an interest rate cut was "on the table" for September. This would mark the first rate cut since the Fed began hiking rates in 2022 to combat inflation and it has left them at elevated levels for the past year.
The U.S. stock market rallied on the news with the Dow DJIA closing up 0.2% on Wednesday. The S&P 500 SPX closed up 1.6% that day, and the Nasdaq COMP was up 2.6%. Meanwhile, consumers breathed a sigh of relief knowing that credit card rates, auto loan rates and mortgage rates could be going down soon.
However, some people were frightened by the idea of lower rates.
A viral chart made the rounds again on social media around the time of the Fed meeting. This chart depicted the U.S. federal funds rate over the years, and overlays when the U.S. economy was in a recession.
The chart portrayed a scary trend. The last few times that the Fed cut interest rates from their peak, a recession followed closely behind. With the Fed gearing up to cut rates again, is the U.S. economy due for another recession?
First of all, it's important to remember that correlation does not imply causation. Rate cuts are certainly related to recessions, but that doesn't mean cutting rates will cause one.
The Fed cuts rates in order to stimulate the economy. Lower interest rates mean money is easier to borrow and flows more freely in the economy. That's antithetical to what a recession is.
A recession is a sustained decline in economic activity. According to the National Bureau of Economic Research, what constitutes a recession is "a significant decline in economic activity that is spread across the economy and that lasts more than a few months." This is signaled by things like elevated levels of unemployment, a decline in personal income and consumer spending and lowered industrial production.
Rate cuts are meant to combat these things. If you go back further and look at the recessions of 1980, 1974, 1970, 1960 and 1957, you'll see that rate cuts came after the recession started, as a way to get the economy out of recession. For the rate cuts that preceded recessions, it was likely that the economic writing was already on the wall and that rate cuts were needed to stop the bleeding.
Same chart as above, but expanded to include previous years.
It's also important to talk about why the Fed is cutting rates in 2024. The Fed began hiking rates aggressively in 2022 to combat rampant inflation in the wake of the supply chain disruptions caused by the pandemic and the government spending that followed to help revive the economy. Inflation usually happens when the economy is hot, and when too much money is going after too few goods and services.
The Fed's recent rate hikes were meant to cool this inflation by slowing down the amount of money circulating the economy. To an extent, it worked. Inflation came down pretty significantly from its 9.1% peak in 2022, but it still remains slightly above the Fed's target rate of 2%.
"It's very important to remember that the Fed is cutting not necessarily because we think a recession is imminent. That's typically the case in previous rate cutting cycles," Jeffrey Roach, chief economist at LPL Financial, told MarketWatch. "The reason why the Fed is cutting is they hiked so aggressively in the previous year and a half. Inflation rates have come down so they can actually cut rates."
This signaled to the Fed that the rate hikes worked at slowing inflation, but the Fed is currently holding rates at these levels in order to slow inflation even more. Starting its rate cut cycle would signal that the Fed is confident it beat inflation, but that hasn't happened quite yet.
Why are people nervous about a recession?
The Fed has a dual mandate from Congress, which is to ensure stable prices and pursue maximum employment. That means getting inflation down without crippling the labor market, and employment data from the past week showed the labor market was starting to cool.
On top of that, Friday's July jobs report showed a decrease in monthly job openings and increase in unemployment. Friday's 4.3% unemployment rate also triggered what is known as the Sahm rule, which says that when the three-month moving average of the unemployment rate is at least 0.5 percentage points above the minimum of the average from the previous 12 months a recession may follow.
So are we in a recession? Not necessarily.
"Typically there's some shock that happens for an economy to get into a recession," Roach told MarketWatch. "The challenge, of course, is how do you forecast a shock?"
For example, the subprime mortgage crisis was the shock that led to the 2008 recession. The rapid spread of Covid-19 was the shock that led to the short recession in 2020. There haven't yet been any meaningful shocks - yet - that would push the economy into a recession in 2024.
And although recession indicators like the Sahm rule, peak interest rates and an inverted yield curve are flashing right now, the economy is being bolstered by strong GDP growth, solid corporate earnings, consumer spending and a labor market that, despite cooling, is still historically strong.
Then why does the economy feel bad? Why are people so eager to say we're in a recession?
That's because normal people are getting hit harder by the not-so-great parts of the economy.
Low-income earners are impacted disproportionally by high inflation, and the middle class isn't nearly as protected from inflation as wealthier people are. Even though inflation is slowing, it's cumulative, so prices are still much higher than they were in 2019 and they're still rising.
Purchasing power has declined while wages rises have slowed, which squeezes the working class, but stagnant wages don't matter if you can't even get a job, and many young people are struggling to get a job due to the cooling labor market.
Go deeper: The job market is showing signs of trouble. These workers are already feeling it.
On top of that, the Fed's higher interest rates have made the American dream of owning a home unrealistic for many. This forced more people to rent, while rents went up. According to Roach, renters "really got taken to the cleaners" with high inflation and increasing rent costs.
All of these things feel really bad for the people experiencing them. Kyla Scanlon, an economic commentator and author of the book "In This Economy? How Money and Markets Really Work" told MarketWatch that structural affordability and media headlines exacerbate negative feelings about the economy. It's also why a chart like the one above has the potential to go viral. Declaring a recession gives the people who are suffering something to validate their feelings.
But are we in a recession? Not at the moment. Is one coming soon? Maybe.
"We had expected a recession slow down to happen maybe at the tail end of this year," Roach told MarketWatch. "I think if the upper-income households can be strong enough and businesses savvy enough to cut costs like they have been doing the last two years, it's possible that we could actually avoid a recession in the near-term."
"Eventually we'll have a recession. It's just kind of normal cycles of the economy," he said. "The key at this point now is the labor market. If the labor market falters that's certainly going to impact disposable incomes and hence consumer spending."
Recessions are just part of the economic cycle. The U.S. is bound to have one eventually in the future. But that doesn't mean you should hold your breath for one. If and when interest rate cuts come, it could help pull the U.S. out of the recession that may or may not happen.
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