Inflation or the Economy: What Will Fed Rate Hikes Break First?

Inflation or the Economy: What Will Fed Rate Hikes Break First?



Published March 29, 2023

The Federal Reserve building at sunset
Douglas Rissing / Getty Images

It’s a mantra for economists: When the Federal Reserve starts hiking rates, it keeps going until something breaks. So what’s going to break next? 

In the past year, the Fed has raised its benchmark interest rate to a range of 4.75% to 5%, the highest since 2006, from near-zero, marking the fastest campaign since the 1980s.  The central bank has cut off the cheap money that kept the economy churning through the pandemic, fueling real estate and stock market booms.1 

That’s put many parts of the economy under stress. The sudden failure of Silicon Valley Bank, the country’s 16th largest bank by assets, raised fear that the financial system is showing cracks, prompting a drastic rescue operation from the government. 

The last time rates were this high, what broke was the entire economy. The 2006 rate hike cycle ended with the collapse of the housing marketthe 2007-2008 financial crisis, and the Great Recession. With inflation and interest rates still running high, and more hikes possible, here’s what economists say could crack next. 

Landlords May Struggling to Repay Loans

Even as some companies try to walk back pandemic-era work-from-home policies, the demand for office space is lower than it was before 2020. Commercial real estate firm Cushman & Wakefield says vacancy rates have increased every quarter for three years and predicted in a recent report that as leases expire, they would surge 55% over pre-pandemic levels by 2030.23 

Those empty offices, whose construction was financed by bank loans, are a ticking economic time bomb for landlords, according to Richard Wolff, a professor emeritus of economics at University of Massachusetts, Amherst.

“They’re in debt up to the wazoo to build the office towers premised on the marketing which told them every office in that place would be leased at a nice flat rate,” he said. “All that’s gone. The offices are empty.”

What space is occupied may be at reduced rents. Combined with lower occupancy, that means office space revenue fell by an inflation-adjusted 17 percentage points between December 2019 and May 2022, according to a study by researchers at NYU and Columbia. That could mean landlords will have trouble repaying those loans-potentially spelling trouble for the banks that made those loans as well.4

“With interest rates trending upward, the economy slowing and demand for office space remaining muted, owners will continue to face difficulties in the foreseeable future,” CommercialEdge, a commercial real estate data company, said in a report last week. “This is especially true for office owners with loans that are maturing in the next three years, which accounts for more than 9,500 buildings and 17% of all office stock.”5

Wolff put it more starkly.

“It’s just a question of when the cascade of office loans crashes on the system,” he said. “Nobody knows how bad it is or what form the disintegration will take.”

Debt Could Spur a `Zombie’ Apocalypse

Nouriel Roubini, a professor emeritus at NYU who has earned the nickname “Dr. Doom” for predicting the 2008 financial crisis, called out a related vulnerability: Highly indebted households, corporations, financial institutions, governments, and countries are in such bad that he labels them “zombies.” 

Those walking dead entities have stayed afloat only because of low interest rates since the Great Recession. They got further support when the Fed cut interest rates to zero during the pandemic.6 

“We kicked the can down the road,” Roubini said on a McKinsey podcast last week. “We bailed out and backstopped a lot of people. But now the game is over, because you have inflation and you have to raise interest rates, as opposed to capping them to zero or negative. So that’s where the risk of the mother of all debt crises occurs.”

Inflation Goes Up in Response to Rate Hikes

The Fed hopes that higher rates will cool inflation, under the theory that higher borrowing costs will discourage lending and spending. With individuals able to buy fewer goods and services and companies able to spend less on salaries and investing in expansion, sellers won’t be able to raise prices as much, workers won’t get big raises. That means supply and demand will rebalance and prices will stabilize. 

It’s possible, though, that companies won’t follow that script. 

Some economists say raising interest rates can make inflation worse. Companies faced with higher costs to service their debt could respond by raising prices and pass along the rate hikes to customers, Tim Di Muzio, a professor of economics at the University of Wollongong in Australia, said in a blog post last year.7 

He says that’’s what happened in the 1980s. Initially, the rate hikes made matters worse, and inflation only subsided when global oil prices plunged, unrelated to the Fed’s actions.

In that scenario, “a rising interest rate will have the perverse unwanted effect of making the inflation worse, not better,” Wolff said.

That can lead to the worst of both worlds—companies raising prices and cutting production, leading to the dreaded combination of inflation and economic stagnation known as “stagflation.”

Banks Aren’t Out of the Woods

Last week, Fed Chair Jerome Powell assured the public that “The U.S. banking system is sound and resilient.”

When Silicon Valley and Signature banks failed, emergency measures by the Fed, the Federal Deposit Insurance Corporation, and the Treasury Department made depositors at Silicon Valley Bank whole and backstopped the entire banking system. So far, no other major U.S. banks have gone under.

However, the subsequent collapse of Swiss bank Credit Suisse, and troubles at First Republic and Deutsche Bank have shown that the global financial system isn’t out of danger just yet, especially if the Fed keeps hiking.

“At the very least, the complex global financial system is showing some cracks,” Alexander Kurov, a professor of finance at West Virginia University, said in an article in The Conversation earlier this month. “Fed officials are right to worry about fighting inflation, but they also don’t want to light the fuse of a financial crisis, which could send the U.S. into a recession.”8

Maybe Nothing Breaks

Granted, the economy has so far resisted the nosedive many experts have feared is just over the horizon. Economists have been predicting a recession for more than a year, and it keeps getting pushed back. Though tech companies that padded payrolls during the pandemic have cut jobs, many companies have kept hiring, and the unemployment rate has been hovering near record lows all year.

In a forecast this week, economists at Fannie Mae said the recent banking turmoil has made a recession more likely—yet it delayed its expected start date to the second half of the year because the economy has proved healthier than they expected.9

The Road Not Taken

The cause of inflation may be simpler than officials like to admit, Wolff said. It might also call for a more straightforward solution.

“What causes inflation is—the answer is very simple—the decision by employers to raise the prices of what their enterprises produce and sell,” Wolff said. “If there’s a supply chain disruption or rising wages or rising taxes but the employer doesn’t want to sacrifice profits, well then he makes the decision to raise prices. No one is holding a gun to his head. He is the author of the price decision and he wants that power.”

Despite the risks that rate hikes pose, they’re the preferred inflation-fighting tool of countries all over the world that are grappling with varying degrees of surging consumer prices. The U.S. once tried a more direct approach that simply made inflation illegal.

In 1971, President Richard Nixon responded to a bout of inflation by ordering a 90-day freeze on price and wage increases, which was later extended. The policy stopped inflation in its tracks, although it came roaring back when the freeze ended, and its long-term effects are still a matter of controversy among economists.10

“Wage price freezes have problems, just like any other policy to control inflation has problems,” Wolff acknowledged. 

However, he said, price controls and other policies aren’t being seriously discussed, despite the downside of rate hikes. Economies are complex systems, and the stress of high rates could cause it to fail in a predictable way, or an unexpected one.

“You’re seeing an economy that is herky-jerky, going from one problem to the next, discovering that the solution to the first one worsens the second one,” Wolff said. “It’s like an ancient person in the last days of their lives in the hospital being told by the doctors, ‘We can’t give you this medication for that disease, because it clashes with the other medication for your other disease.’ And at a certain point, you say goodbye to everybody you love and it’s over.”