What exactly is a recession

A recession is not just a slowdown in growth but negative growth. According to the classical economics definition, 2 consecutive quarters of GDP contraction is defined as recession. Larry Summers, former US Treasury Secretary, feels the economic conditions were already ripe for an economic recession in the US. The aggressive rate hikes, combined, with bond book unwinding, would most likely precipitate a recession over the next 2 years, according to Summers. 

What were the options for Fed?

For the Fed, it was a choice between the devil and the deep sea. They had to raise rates. With inflation at 8.5%, they had to do it really fast and even amplify it with bond book unwinding. Summers has a different perspective. His view is that the Fed delayed the start of rate hikes by too long. Rate hikes may have been effective when inflation was at 4% not when inflation is at 8.5%. Due to the new monetary approach adopted by the Fed in 2020 to prioritize growth over inflation control, the inflation battle had been delayed unnecessarily. That, in the view of Summers, is the key factor that could make rate hikes recessionary. 

Inflation and unemployment

According to Summers, the problems for the US economy arise from a mix of too high inflation and low unemployment. In the US, wages have been rising at 6.6% annualized, which means consumer demand may remain robust even with interest rate hikes. Hence, rate hikes may not necessarily bring down prices to the extent envisaged. Also, a spike in interest rates would mean cost of funds will be high for corporates and hence any investments in enhancing supply would be limited and calibrated. As a result, the main problem of demand struggling to keep pace with supply is most likely to continue, at least for now. 

What about a recession then?

In the last 100 years, inflation above 4% and unemployment below 5% has led to recession within 2 years in 90% of the cases. The only two occasions in 1984 and 1994, when rate hikes did not cause a recession, was when inflation was much lower and unemployment was much higher. The US markets are taking solace from the 2000 scenario, when the Fed had embarked on a very aggressive round of rate hikes. This, had to be curtailed after 9/11, which actually saved the US economy from a full-fledged recession. Unless there is a shock that forces the US Fed to once again loosen, it looks like the current situation may trigger a US recession. That is not great news for markets!