Why Is This Time Different?

Many have been asking this question since earlier this year, a question that has no easy answer. As economists – us included – continue to forecast the most ‘telegraphed’ recession in history, it is important to point to those things that make this economic cycle very different from past economic cycles. These differences are having an undeniable effect on Americans’ ability to weather the higher interest rate storm and is making the economy’s response to higher rates very different than in previous cycles.

First of all, this was not a typical monetary cycle and thus, the cycle is not showing the same characteristics of a typical end of a monetary cycle. Normally, the Federal Reserve (Fed) decreases interest rates to reactivate the economy through one of its monetary channels: lower interest rates increase lending by banks through the money multiplier effect. That is, the Fed buys Treasurys from the market, injecting liquidity into the market and thus lowering interest rates. Then banks/financial institutions lend those funds to customers, increasing the money supply. The cycle reverses when the Fed decides to sell Treasurys into the market in order to “dry” it from excess liquidity, which makes banks reduce lending, reversing the growth in money supply. Sometimes, during the monetary expansion cycle, borrowing increases so much that individuals and households get into trouble because they cannot continue to pay their debts, especially if employment deteriorates. A very similar process happens with firms, as credit becomes cheaper, and firms increase investments.

In a nutshell, and perhaps a bit oversimplified, this is what a normal monetary cycle looks like. So, when the Fed pulls the trigger and starts increasing interest rates, those individuals who lose their jobs in a downturn get in trouble. Also, firms that invested too much find it difficult to pay back their debts during a recession.