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Can Rising Interest Rates Trigger a Recession? Here's What to Know

hundred dollar bills clipped with clothespin behind fence, inaccessible
Sarah Tew/CNET

What's happening

The Federal Reserve is trying to cool the economy by hiking interest rates without causing a downturn, but experts say a "soft landing" is looking less probable.

Why it matters

With the Fed's projections to continue raising rates, there will be consequences -- most likely an uptick in unemployment.

What it means for you

Soaring consumer prices, tumbling stocks, increased costs to borrow money and the threat of layoffs could prove particularly devastating for low- and middle-income Americans.

Is it worth risking a recession to control inflation? That's one question many economists are now pondering. 

Historically, raising interest rates is a key tool the Federal Reserve uses to put a lid on rampant inflation. In fact, it's the only tool the central bank has to counter soaring prices. When rates go up for credit cards, mortgages and other loans, borrowing money becomes more expensive and spending is less appealing. That, in turn, should theoretically slow demand, putting more pressure on businesses to reduce prices so consumers will buy their products.

But bumping up rates hasn't been effective so far this year, with inflation remaining stubbornly steep. The most recent reading in May showed consumer prices rising at an annual rate of 8.6%, the highest in a generation. After the Fed's latest rate increase -- the largest since 1994 -- the central bank is projecting more interest rate hikes, possibly another 0.5- to 0.75-percentage point increase as soon as July. 

Experts are concerned that if the Fed goes overboard in trying to slow the economy, it could contract too much and trigger a recession. Just last week, Fed chief Jerome Powell explicitly warned of that scenario, stating that a so-called soft landing, or reaching 2% inflation while keeping the labor market strong, will be "challenging." 

What's causing this record-high inflation level? And what does the Fed plan to do next? What's the probability of a recession? Here's everything you need to know.

How bad is inflation right now?

In May, inflation surged to 8.6% over the previous year, reaching its highest level since December 1981, according to the Bureau of Labor Statistics. Gas prices rose 4.1% in May, bringing the increase in gas prices to 48.7% over the past 12 months. Food prices also increased by 1.2% in May, bringing that 12-month increase to 10.1% overall. 

During periods of high inflation, your dollar has less purchasing power, making everything you buy more expensive, even though you're likely not getting paid more. In fact, more Americans are living paycheck to paycheck, and wages aren't keeping up with inflation rates. 

What caused inflation to get so high this time?

In short, a lot of this can be attributed to the pandemic. In March 2020, the onset of COVID-19 caused the US economy to shut down. Millions of employees were laid off, many businesses had to close their doors and the global supply chain was abruptly put on pause. This caused the flow of goods produced and manufactured abroad and shipped to the US to cease for at least two weeks, and in many cases, for months, according to Pete Earle, an economist at the American Institute for Economic Research.

But the reduction in supply was met with increased demand as Americans started purchasing durable goods to replace the services they used prior to the pandemic, said Josh Bivens, director of research at the Economic Policy Institute. "The pandemic put distortions on both the demand and supply side of the US economy," Bivens said. 

Though the immediate impacts of COVID-19 on the US economy are easing, labor disruptions and supply-and-demand imbalances persist, including shortages in microchips, steel, equipment and other goods, causing ongoing slowdowns in manufacturing and construction. Unanticipated shocks to the global economy have made things worse -- particularly subsequent COVID variants, lockdowns in China (which impacts the availability of goods in the US) and the war in Ukraine (which affects gas prices), according to the World Bank.

Powell confirmed the World Bank's findings at the Fed's June meeting, calling these external factors challenging because they are outside of the central bank's control

In recent weeks, some lawmakers have accused corporations of seizing on inflation to increase prices more than necessary, a form of price gouging.

What does the Federal Reserve have to do with inflation?

With inflation hitting record highs, the Fed was under a great deal of pressure from policymakers and consumers to get the situation under control. One of the Fed's primary objectives is to promote price stability and maintain inflation at a rate of 2%. 

By raising interest rates, the Fed aims to slow down the economy by making borrowing more expensive. In turn, consumers, investors and businesses pause on making investments and purchases with credit, which leads to reduced economic demand, theoretically reeling in prices and balancing the scales of supply and demand. 

The Fed raised the federal funds rate by a quarter of a percentage point in March, followed by a half of a percentage point in May and three-quarters of a percentage point in mid-June. The federal funds rate is the interest rate that banks charge each other for borrowing and lending. And there's a trickle-down effect: When it costs banks more to borrow from one another, they offset it by raising rates on their consumer loan products. That's how the Fed effectively drives up interest rates in the US economy. 

The federal funds rate now sits at a range of 1.5% to 1.75%. But the Fed thinks this needs to go up significantly to see progress on inflation, likely into the 3.5% to 4% range, according to Powell.

However, hiking interest rates can only reduce inflationary pressures so much, especially when the current factors are largely on the supply side -- and are worldwide. A growing number of economists say that the situation is more complicated to get under control, and that the Fed's monetary policy alone is not enough.

How would increased interest rates spark a recession?

We can't yet determine how these policy moves will broadly impact prices and wages. But with another three rate hikes projected this year, there's concern that the Fed will overreact by raising rates too aggressively, which could spark a more painful economic downturn or create a recession

The National Bureau of Economic Research, which meets in July and will officially determine if the US is in a recession, defines a recession as "a significant decline in economic activity that is spread across the economy and lasts more than a few months." That means a declining gross domestic product, or GDP, alongside diminishing production and retail sales, as well as shrinking incomes and lower employment. 

Pushing up rates too quickly might reduce consumer demand too much and unduly stifle economic growth, leading businesses to lay off workers or stop hiring. That would drive up unemployment, leading to another problem for the Fed, as it's also tasked with maintaining maximum employment. 

In a general sense, inflation and unemployment have an inverse relationship. When more people are working, they have the means to spend, leading to an increase in demand and elevated prices. However, when inflation is low, joblessness tends to be higher. But with prices remaining sky-high, many investors are increasingly worried about a coming period of stagflation -- the toxic combination of slow economic growth with high unemployment and inflation. 

What do rising interest rates mean for you?

For the past two years, interest rates had been at historic lows, partially because the Fed slashed rates in 2020 to keep the US economy afloat in the face of lockdowns. The Fed kept interest rates near zero, a move made only once before, during the financial crisis of 2008. 

For the average consumer, increased interest rates means buying a car or a home will get more expensive, since you'll pay more in interest. Higher rates could make it more expensive to refinance your mortgage or student loans. Moreover, the Fed hikes will drive up interest rates on credit cards, meaning that your debt on outstanding balances will go up. 

Securities and crypto markets could also be negatively impacted by the Fed's decisions to raise rates. When interest rates go up, money is more expensive to borrow, leading to less liquidity in both the crypto and stock markets. Investor psychology can also cause markets to slide, as cautious investors may move their money out of stocks or crypto into more conservative investments, such as government bonds.

On the flip side, rising interest rates could mean a slightly better return for your savings accounts. Interest rates on savings deposits are directly affected by the federal funds rate. Several banks have already increased annual percentage yields, or APYs, on their savings accounts and certificates of deposit in the wake of the Fed's rate hikes.

We'll keep you updated on the evolving economic situation as it develops.