Can the Economy Weather the Storm of Rising Rates and Rising Debt Levels?

AT A GLANCE

  • U.S. debt levels are more than twice as high today as they were during the economy of the late 1970s and early 1980s
  • The Fed Funds Futures curve suggests that the Fed will tighten once more in Q1 2023 and then slash rates from 5% to 3% by the end of 2024

In 2022, the Fed raised rates by 425bps, the biggest policy tightening in a single year since 1981. How worried should we be about the economic impact of such large rate hikes?  

The twin tightening cycles of 1979 and 1981 both resulted in a deep, double dip recession. But the ’79 and ‘81 tightening cycles were twice as big as the one we’ve been through this year; then, rates went to 20%, whereas this time the Fed might not even get rates to 5%. 

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But there is one major difference between the economy of 2022 and the economy of the late 1970s and early 1980s: debt levels are more than twice as high today as they were then. Back in the late Carter and early Reagan eras, the total public and private sector debt to GDP ratio was around 130%. Today it is twice that amount, around 260%. And it raises the question: given the level of leverage in the public and private sectors, can the U.S. economy support such large rate hikes without suffering a downturn? 

Fed Funds Futures suggest that bond traders think that the answer to this question is no. The Fed Funds Futures curve suggests that the Fed will tighten once more in Q1 2023 and then it will slash rates from 5% to 3% by the end of 2024. Fixed income investors appear to be concerned that the Fed’s recent tightening may slow U.S. economic activity too much.

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