Will Rising Rates Cause Our Next Recession?

The Next Recession in Banking

Some pundits and economists are sounding alarms that by increasing interest rates too fast or too high, the Federal Reserve might cause the next recession.  However, we believe that bankers should direct their concerns to other economic and credit developments – such as low cap rates, high LTVs, and dubious pro forma cash flows.  We believe that the likelihood of a Federal Reserve policy error causing the next recession is exceedingly low, and the cause and effect between short-term interest rates and recessions is not so obvious.

    

Correlation versus Causation

 

We have been taught to distinguish correlation and causation.  But the difference can be difficult to identify because people are evolutionarily predisposed to see patterns where none exist, and psychologically inclined to gather information that supports their pre-existing views.  We sometimes confuse coincidence with correlation and correlation with causation. 

 

There are at least three requirements to promote that A causes B: 

 

  1. A must precede B,
  2. A and B vary together, and
  3. No competing explanation can better explain the covariance of A and B. 

 

These requirements are at least necessary to promote causation, but cannot prove it sufficiently. For example, homeless population and crime rate might be correlated, but it is hard to say that crime causes homelessness, or homeless people cause crime, or another underlying cause leads to crime (drug abuse, or unemployment).

 

Without diligent reasoning, one may conclude from the chart below that high fructose corn syrup causes people to get married in Florida. Now, you are talking about a state that has an underwater music festival (tickets to purchase are HERE) so we would not blame you for believing there is weird stuff going on in Florida, but this strong correlation (in this case R-squared of 0.97) is not an example of causation.

 

Correlation and Causation

 

Historical Evidence

 

Except for the 1980 recession and the Great Depression, it is hard to show a causal relationship between the actions of the Federal Reserve and recessions.  The graph below shows the Fed Funds rate from 1988 in the white line and US recessions in the red line.  The pattern below shows that the Federal Reserve is responding to the onset of recessions by cutting interest rates, and not causing recessions by raising rates.   

Interest Rates and Recession

 

We are proponents of behavioral economics and the work of Daniel Kahneman, a psychologist with no formal economics training who won a Nobel Prize in economics.  Behavioral economics states that people’s emotions, cognitive errors and other psychological factors influence their decisions and economic recessions are more likely caused by a loss of business and consumer confidence and not by actions of the Federal Reserve.

 

The following factors are likely to cause the next recession:

 

  1. Overconfidence that property prices will only go up and cap rates will never migrate to long-term averages;
  2. The fantasy that pro forma cash flows will materialize; and
  3. The exuberance by lenders to continue to extend LTVs to higher and higher levels to compete for marginal loans.  The lending market is now so convinced they will do well that many participants are taking unnecessary risks for only marginal revenue.

 

But like every other business cycle in modern history, confidence will recede, and when it does, so does demand.  When overconfident risks pay off, the economy booms, but when the overconfidence leads to losses, consumers and business retract, the business cycle turns, and a contraction ensues.  Overconfident people have particularly short memories.

Conclusion

 

Many factors may coincide with a recession (increase in interest rates, credit crunch, asset bubbles or major geopolitical events).  However, the cause of most recessions is a behavioral shift in loss of confidence in the economy.  After many years of economic gains, decreasing cap rates, and increasing cash flows, consumer and business behavior will shift (as it always has in the past).  The principles of behavioral economics can be seen today in overly optimistic lending practices.  Bankers should be paying particular attention to protect their credit portfolio from the next behavioral shift and be less concerned about risks associated with rising in short-term interest rates.