Specific market bubbles (like dot-com or AI) popping don't typically cause broad recessions. Historically, the Fed creates a boom by lowering rates, then triggers a bust by raising them to fight the resulting inflation. This cycle is the true culprit of most recessions.
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An AI stock market bubble, like the dot-com bubble of the late 90s, is primarily equity-financed, not debt-financed. Historically, the bursting of equity bubbles leads to milder recessions because they don't trigger systemic failures in the banking system, unlike collapses fueled by debt.
In an interest rate-driven cycle, the housing market feels the impact first. Historically, an 8% drawdown in residential construction payrolls precedes a broader recession. The absence of this drawdown, due to labor hoarding by builders, is a key reason the US economy has remained resilient.
Recent inflation was primarily driven by fiscal spending, not the bank-lending credit booms of the 1970s. The Fed’s main tool—raising interest rates—is designed to curb bank lending. This creates a mismatch where the Fed is slowing the private sector to counteract a problem created by the public sector.
Former RBI Governor Raghuram Rajan points to a historical pattern preceding every major financial crisis: a U-shape in monetary policy. An extended period of easy money builds up risk, and the subsequent tightening phase triggers the collapse. This framework helps identify periods of heightened systemic vulnerability.
A common misconception is that Fed rate cuts lower all borrowing costs. However, aggressive short-term cuts can signal future inflation, causing the 10-year Treasury yield to rise. This increases long-term rates for mortgages and corporate debt, counteracting the intended economic stimulus.
Contrary to the popular memory of him letting the 90s boom run hot, Alan Greenspan's Fed aggressively hiked rates to 6.5% by 2000. This was a preemptive move to curb inflation and irrational exuberance, even amid strong productivity growth.
A popular chart showing U.S. job openings diverging from the S&P 500 post-ChatGPT is misleading. The actual inflection point aligns with the Federal Reserve's earlier rate hiking cycle, indicating that macroeconomic policy, not AI, has been the primary driver of this labor market trend so far.
The Fed's tool of raising interest rates is designed to slow bank lending. However, when inflation is driven by massive government deficits, this tool backfires. Higher rates increase the government's interest payments, forcing it to cover a larger deficit, which can lead to more money printing—the root cause of the inflation in the first place.
The current economic cycle is unlikely to end in a classic nominal slowdown where everyone loses their jobs. Instead, the terminal risk is a resurgence of high inflation, which would prevent the Federal Reserve from providing stimulus and could trigger a 2022-style market downturn.
The reason for the Fed's rate cuts is critical. A "good" cycle with firm growth and declining inflation leads to strong commodity returns. Conversely, a "bad" cycle with decelerating growth and sticky inflation results in negative returns, making the 'why' more important than the 'what'.
