The Lag Effect Will Trigger a Recession

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There are few signs that surging interest rates are impeding economic activity or causing distress amongst borrowers. It may seem strange that higher rates are not troublesome for such a highly leveraged economy.

But don’t breathe a sigh of relief.

There is often a delay, called the “lag effect,” between higher interest rates and economic weakness.

Changes in interest rates impact only new borrowers, including those with maturing debt who must refinance to pay back investors of the maturing bonds. Nor do higher rates impact those with fixed-rate debt that is not maturing. The lag effect occurs due to the time it takes for new-debt issuance to bear enough weight on the economy to slow it down.

The graph below shows the Fed funds rate and the time, as measured in months, from the last in a series of rate hikes preceding until the next recession since 1981. The average delay between the final rate increase and recession has been 11 months. The last Fed hike was in July 2023. Assuming that was the Fed’s final rate increase for this cycle, it may not be until June 2024 before a recession occurs.

fed funds

This lag effect was even more pronounced when rates were very low for extended periods before the rate hikes.

I examine government, corporate, and consumer debt to evaluate the current lag effect and better gauge when it will impair economic growth.