Will the Next Federal Reserve Rate Hike Drive Us Closer to a Recession?

Here's why it could.

It's hardly a secret that inflation has been hitting consumers hard for the past year. And the Federal Reserve wants to put an end to that.

As such, the Fed has been raising interest rates this year, and last month, it implemented its highest rate hike in almost three decades. Meanwhile, the Fed is set to meet again later this month, at which point it's fair to assume that it will once again increase interest rates.

But while higher interest rates might help cool inflation, they could also lead to a full-blown recession. And that's something Americans will need to prepare for.

Why higher interest rates could lead to a recession

The Federal Reserve does not set consumer borrowing rates (like mortgage rates and personal loan rates) directly. Rather, it sets the federal funds rate, which is what banks charge one another for short-term borrowing.

But when the Fed raises the federal funds rate, consumer borrowing rates tend to trend in the same direction. As such, following the next Fed meeting, we could see an uptick in credit card interest rates, auto loan interest rates, and home equity line of credit rates, to name a few.

That's not totally a bad thing, because what it might do is cause consumers to start spending less at a time when the cost of goods is so high. If consumer spending declines, it will narrow the gap between the supply of available goods and the demand for them. And that, in turn, could finally drive living costs downward.

But if borrowing gets so expensive that consumers cut their spending to an extreme, it has the potential to spur an economic recession. And that could mean widespread layoffs and other unfavorable consequences.

How to prepare for an economic decline

If the Fed's actions do end up spurring a recession, it could be a mild one or a prolonged one; there's really no definitive way to know. That's why it's smart to prepare for a recession as best as you can.

If you don't have a full emergency fund -- enough to cover at least three full months of essential living costs -- then spend the next few months boosting your savings rate. It's important to have plenty of cash reserves during a recession in case your work hours are cut or you're laid off.

Next, try whittling down unhealthy debt, like your credit card balance. With interest rates rising, that debt is likely going to cost you more in the near term. But also, the less debt you have hanging over your head, the less stress you might feel if you do end up losing income during a recession.

Finally, consider unloading some expenses that aren't necessities. That could mean canceling the gym membership you rarely use or pausing a subscription box. Those moves could free up more cash for savings and debt payoff purposes.

While a recession isn't guaranteed to hit this year or next, the actions the Fed is taking to cool inflation could result in one. That's a tough reality to face, but it's better to prepare for a downturn than to get caught off guard by one.