What happens to interest rates during a recession?

Interest rates typically fall during recessions as loan demand slows, bond prices rise, and the central bank eases monetary policy. During recent recessions, the Federal Reserve has cut short-term rates and eased access to credit for municipal and commercial borrowers.

No price in the economy is as important as the price of money. Interest rates are arguably the engine of the economic cycle of boom and bust. Market rates reflect borrowers’ demand for credit and the supply of available credit, which in turn reflects shifts in preference between savings and consumption.

Key points to remember

  • Interest rates typically fall during a recession when demand for loans declines and investors seek security.
  • A central bank can lower short-term interest rates and buy assets during a downturn.
  • These actions directly affect the economy and signal the central bank’s intention to maintain an accommodative monetary policy for longer.
  • Once the economy begins to recover, a central bank may partially or fully reverse these policies to stem inflation.

Supply and demand

Loan demand can be one of the first victims of a recession. As economic activity weakens, companies put on hold expansion plans that they would otherwise have financed with debt. Consumers worried about their jobs as layoffs spread are starting to spend less and save more.

It is also possible that lenders pull out in the event of a financial crisis, subjecting the economy to the additional pain of a credit crunch and forcing a central bank with a mandate to deal with such systemic threats to intervene.

In the absence of a credit crunch, interest rates fall during a recession because the recession suppresses the demand for loans while stimulating the supply of savings.

In fact, this trend anticipates recessions, as shown by an inverted yield curve that frequently precedes a downturn. A yield reversal occurs when the yield of a longer-dated Treasury bill falls below that of a shorter-dated note.

So if the yield on the 10-year treasury falls below that of the two-year treasury, for example, it usually happens because investors are already anticipating economic weakness and are moving into fixed-income maturities at longer term that tend to outperform during downturns. .

Role of the Central Bank

Central banks practice countercyclical monetary policy, easing the money supply during recessions when economic activity and inflation slow, and tightening it if necessary during recoveries.

The main tools available to the Federal Reserve are its control of the federal funds rate and its balance sheet. And while these tools work over time, they are not instant cures.

When the Fed lowers the target federal funds rate, which is the rate banks charge themselves for overnight reserves, it eases financial conditions at the margin and hopes the effect will spread throughout the economy. . In fact, the transmission channels of this monetary policy can be blocked, as when low interest rates do not stimulate the purchase of houses because many potential buyers cannot obtain credit, for example.

Following the 2008 financial crisis, central banks in the United States, Europe and Japan kept short-term interest rates close to zero for years to contain downside risks to growth. economic. When that proved insufficient, they engaged in large-scale asset purchases, also known as quantitative easing.

Asset purchases serve to increase demand for the purchased assets – typically longer-term government debt or mortgages – thereby reducing yields, which are interest rates on fixed-income securities.

Like changes in the federal funds rate, large-scale asset purchases also pass through the expectations channel, signaling a central bank’s intention to keep monetary policy loose for longer.

Since a sovereign currency issuer’s central bank has an unlimited supply of funds for asset purchases and short-term rate targeting, the signaling function can be particularly effective.

As expectations of a recovery begin to be reflected in inflation and asset prices, the central bank may raise rates and shrink its balance sheet.

The essential

Interest rates fall during a recession due to reduced demand for credit, increased savings, and a flight to safety into treasury bills. The decline also anticipates a central bank’s likely response to the economic downturn, which may include cuts in short-term interest rates and large-scale asset purchases of extended-maturity debt securities.

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