Fed policy decision: Could higher rates trigger a recession?

While markets are hanging on the words of the Federal Reserve ahead of officials' interest rate decision on Wednesday, recession talks are beginning to reenter the conversation. Could the Fed's monetary policy of holding rates higher for longer ultimately lead to a recession?

Yahoo Finance Markets Reporter Josh Schafer eyes the key economic data the Fed is considering as regulators vote on a March rate decision.

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

Editor's note: This article was written by Luke Carberry Mogan.

Video Transcript

SEANA SMITH: If we do see any adjustment in the dot plot, I'd say it goes down, maybe only two cuts before the end of the year. Maybe only 25 basis points of cuts for the end of the year. What-- does that do anything to raise the risk of a recession?

JOSH SCHAFER: The key with that would be right, so remember last year everyone had a recession call because of how tightening normally works. We tighten lending standards, we tighten lending conditions. Companies have to pay more to borrow money and then eventually they need to make up for those costs somewhere. You usually see that in layoffs and then you have a problem in the labor market.

Then people have less money and then we have this whole spiral and that's how you get to a recession. That was why the 2023, recession call was so popular. Well, when I talk to economists at the end of the year, they said, quite simply history didn't repeat itself like it normally does. In some ways, this time thus far has been different because of the different aspects of the COVID 19 pandemic.

And the unraveling of that in the stimulus we put in the economy, a concern among economists still is, yes, we're doing very good now. But what if we keep rates higher for longer? What if they don't cut at all this year? At what point could that maybe have some filter through? And so you mentioned the dot plot on the thing to highlight here, is it's still called the summary of economic projections?

We're talking a lot about dots and we're talking a lot about are we going to see two cuts or one cut when we look at that dot plot? But also key to note in this summary of economic projections, does the Fed see GDP going up? Because they don't have a very high projection for GDP for this year now. It's not as high as the streets. Do they agree with Wall Street that we are doing better as an economy?

What is the unemployment rate that they see at the end of this year? Remember the unemployment rate just ticked up from 3.7% in January to 3.9% in February, that is normally a little bit of at least a yellow signal for people if that continues. Because once the unemployment rate continues to tick up a little bit more and we hit that-- some rule on a three month basis-- of we're seeing it start to tick up, that is when it spirals.

So it'll be interesting just to see overall, I think what Jerome Powell says about the state of the economy. Not just today, but moving forward in these meetings. He has been very outspoken in the last couple meetings, talking positively about the economy. The economy is surprised us, the economy is performing well, consumers are in good shape. Does that hold up?

Because now we have plenty of strategists that have come on this air that are saying, if we take away a cut it might not matter for stocks. Things are still can be OK. The next thing they say, is because the economy is doing well. The economy is the key here, if we're going to stay higher for longer.

If we can stay resilient and maybe we don't get a ton of information on that yet, because we haven't seen the data fully fall off. But it's going to be the thing to watch. I think, between this meeting and next meeting and going into June, July. When we're worried about if we're going to get a cut.

BRAD SMITH: How much do you think we get a clear signal from the Fed here? As I'm sitting here looking at the CME Fed watch probability tool, that says, in June 60% probability of a cut.

JOSH SCHAFER: Is he ever clear? I feel part of his job is seriously though, is to not be overly clear. Because I think to give it away-- to basically talk around it and say that they still need more confidence in things like that. Because Brad, I think, when we look at how the rise in markets in some ways loosens financial conditions. And if we were to have yields fall again significantly today, you're loosening conditions at some point.

I don't think the Fed wants to see a 2% rally after today's meeting. I don't think we need that now, I don't think they need that. I think perhaps, maybe the tick up in yields and a little bit of tightening that's done. As the market is readjusted, has helped the Fed in some ways in keeping things tight.

SEANA SMITH: Yeah. I just think what's going to be so interesting and listening to Powell's testimony here. This afternoon is just going to be going off of what you were saying. This rising risk of recession, if in fact, the Fed does hold rates higher for longer, just how that's factoring into their thinking now? In terms of how he's even assessing that situation and that risk out there?

Because even in the most recent notes that we're getting from top economists, from top strategists, on the street there is a pretty wide gap in terms of, what that real risk is? And how quickly-- if the Fed does in fact, keep rates too high, how quickly they are able to reverse some of the damage that would have already been done at that Point?

JOSH SCHAFER: I'd be curious if someone uses the phrase maintenance cuts when they're asking him questions today because that's what a lot of economists call it. We're talking about maybe two rate cuts this year, maybe 3. 50 basis points or 75 basis points. It's not huge. But they call them maintenance cuts for a reason and it's to make sure you're giving the economy a little bit of help.

It's not to really loosen things, we don't need a lot of help now. You would if you were potentially going into a recession but it's a maintenance cut. It's a little bit of a trim. Just OK, we're still waiting for inflation to come down. We feel relatively confident in that trend, which is cut by 25 maybe in the first half of this year. Or maybe starting in the second half this year, just to help folks out a little bit.

It would also maybe help out some of the issues you're seeing in the housing market. And the Fed has only so much it can do there, but it would probably help bring mortgage rates down. It just gives a little bit of overall loosening to the economy and you'd think at some point this year, maybe we need that. Or maybe the resilient consumer just holds up and every economic data point keeps beating for the next 12 months.

SEANA SMITH: That is true.

BRAD SMITH: A resiliency tree, just peppered--

SEANA SMITH: You can't rule anything out.

BRAD SMITH: Great, Josh. Thanks so much.