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CAPITAL IDEAS: Are higher interest rates helping the economy?

Recessions in the U.S. occur fairly regularly despite the level of interest rates. This begs the question: Is the U.S. economy booming despite higher interest rates or because of them?

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The Federal Reserve has a dual mandate: to achieve maximum employment and keep prices stable. The Fed’s favored price gauge is the Core Personal Consumption Expenditures (PCE) Index. The PCE is an alternate metric to the more widely known Consumer Price Index (CPI). “Core” excludes more volatile components, such as food and energy.

The Core PCE’s year-over-year growth rate ended 2020 at 1.7 percent and had been relatively stable or below the Fed’s two percent target for the previous three decades, not three years—three decades. It took about two years for the Core PCE’s year-over-year growth rate to shoot up to 5.6 percent by January 2022.

Chart courtesy of the U.S. Bureau of Economic Analysis.

On March 17, 2022, the Federal Reserve started an interest-rate-hike campaign that lasted more than two years and increased the federal fund’s interest rate by five percentage points. Once that hiking campaign began, as you might intuit, economic pundits, households, corporations, and the run-of-the-mill guy on the street predicted a recession to begin later that year or in 2023. That recession never came, and based on metrics such as Gross Domestic Product (GDP), unemployment, and corporate profits, the economy is now performing as well as or better than at the start of the hikes.

Chart courtesy of Bloomberg.

Still, I will proudly take a victory lap on that one. I opined that the much-predicted recession was most likely behind us in the form of two consecutive contractions in U.S. Gross Domestic Product (GDP) in the first two quarters of 2022. What I called a recession never officially met the unofficial-official definition as described by the National Bureau of Economic Research. After those two quarters, GDP growth has been on fire despite ultra-high interest rates.

Chart courtesy of the U.S. Bureau of Economic Analysis.

All things are relative. Although current interest rates may be “ultra” high compared to a few years ago, they are not out of line with historical rates. Other than periods of crisis, such as the Technology Bubble Collapse of 2000–2002 and the multi-year “zero interest rate policy” following the Financial Crisis of 2007–2009, current interest rates are in line with or even lower than the federal funds rate from 1972 to 2007.

Chart courtesy of the Federal Reserve.

Throughout that stretch from 1972 to 2007, there were five recessions, or one every five years. From 2007 until today (including the one I call a recession but was not officially declared one), there were three recessions, or one every 5.6 years (it would be one every 8.5 years if we didn’t include the “Allen” recession).

Recessions in the U.S. occur fairly regularly despite the level of interest rates. This begs the question: Is the U.S. economy booming despite higher interest rates or because of them?

Consider that even as interest rates were at recent highs, U.S. retail sales in March 2024 rose a whopping 0.7 percent month-over-month and up 4.0 percent year-over-year. Spending has helped support the economy throughout the last few years (even as it has come off its massive post-pandemic shutdown spike). Consumer spending on goods and services accounts for roughly two-thirds of U.S. GDP. Higher interest rates from some sources have fueled those purchases. Generally, banks have yet to help much in that regard.

Many banks still offer near-zero yields in their savings and checking accounts. Therefore, many households are buying U.S. Treasury bonds and “Money Funds” to boost their yield.

Placing $1 million of cash in an S&P 500 index fund is a great investment for many people, but that is meant to be a long-term holding. More conservative investors or those with cash-flow needs could place that same $1 million into the Schwab Value Advantage Money Fund, which not only keeps a stable value but yields more than five percent, which would generate the investor an extra $50,000 per year of income. According to Statista, Americans hold nearly $1 trillion of savings—that is a potential additional $50 billion of household stimulus compared to having the cash in low-yielding bank accounts.

As the Fed raised the federal funds interest rate, investors took advantage of the higher yields and snapped up U.S. Treasuries, which have paid a range of roughly four to five percent since the end of December 2022 (compared to nearly no yield at the start of 2022). According to Goldman Sachs, U.S. households owned two percent of the Treasury bond market at the beginning of 2022, when interest rates were low. Higher yields attracted yield-sensitive savers, and now U.S. households own nine percent of the $27 trillion Treasury market. That is another $100 billion of extra annual income paid to Americans.

It is also notable that, as of June 30, 2023, U.S. corporations hold about $4 trillion in cash, which is $1.25 trillion above their long-term trendline. That is potentially an extra $137 billion in interest paid to U.S. corporations annually.

The increase in interest rates from roughly zero to five percent has provided a potential additional $300 billion of income to households and corporations. Correlation is not causation, but evidence to suggest that higher interest rates have been stimulative to the U.S. economy.

To be certain, most traditional economic theories would consider this hypothesis to be misguided because, historically, higher interest rates choke off growth. However, this time, a massive amount of pandemic-era stimulus flowed into the economy to buoy household and corporate spending over the previous few years. Much of that stimulus has yet to be spent or even allocated; households still have excess savings, and municipalities still have ARPA money to spend. Fiscal policy has kept a much-predicted recession at bay, keeping higher interest rates from doing as much harm in the past, to the point where they may now be a net tailwind, not a headwind.


Allen Harris is an owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.

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