Despite surging interest rates, there are few signs they are impeding economic activity or causing distress amongst borrowers. It may seem strange that higher rates are not proving troublesome for an economy with such a high amount of leverage. Don’t breathe a sigh of relief quite yet. There is often a delay, called the lag effect, between higher interest rates and economic weakness.
Changes in interest rates only impact new borrowers, including those with maturing debt who must reissue debt to pay back investors of the maturing bonds. Accordingly, higher rates do not impact those with fixed-rate debt that is not maturing. The lag effect occurs due to the time it takes for the 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 each 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.
This so-called lag effect is even more pronounced when rates were very low for extended periods before the rate hikes. We examine government, corporate, and consumer debt to appreciate the current lag effect and better gauge when it will rear its ugly head.
There is over $32 trillion of U.S. Treasury debt outstanding. Simple math asserts that each 1% increase in interest rates pushes the government’s interest expense up by $320 billion. That math is wrong.
The reality is only a small portion of the federal debt matures in any given month and must be reissued. Further complicating
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