Interest rates typically decline 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 credit access for municipal and corporate borrowers.
Interest rates have an influence on the business cycle of expansion and contraction. Market rates reflect credit demand from borrowers and the available credit supply, which in turn reflects preference shifts between savings and consumption.
Key Takeaways
- Interest rates usually fall in a recession as loan demand declines, investors seek safety, and consumers reduce spending.
- A central bank can lower short-term interest rates and buy assets during a downturn to stimulate spending.
- Those actions affect the economy directly and signal the central bank’s intent to keep monetary policy accommodative for longer.
- Once the economy starts to recover, a central bank may partially or fully reverse those policies to slow growth and stem inflation.
Interest Rates and Supply and Demand
Loan demand can be an early casualty of a recession. As economic activity falters, companies shelve expansion plans they otherwise would have financed with borrowings. As layoffs spread, consumers worried about their jobs start spending less and saving more.
It’s possible for lenders to pull back in a financial crisis as well, subjecting the economy to the additional pain of a credit crunch and forcing a central bank with the mandate to address such systemic threats to intervene. Absent a credit crunch, interest rates fall in a recession because the downturn suppresses loan demand while stimulating the supply of savings.
In fact, that tendency precedes recessions, as shown by an inverted bond yield curve that frequently foreshadows a downturn. A yield inversion occurs when the yield on a longer-dated Treasury note falls below that on a shorter-dated one.
If the 10-year Treasury note’s yield falls below that of the two-year Treasury note, for example, it typically signifies that investors are already anticipating economic weakness and opting for the longer-dated fixed-income maturities that tend to outperform in downturns.
The economy usually grows when interest rates are low and money is cheap to borrow, and weakens when central banks reverse this policy to tackle inflation.
Can Interest Rates Cause a Recession?
In certain cases, central banks may be compelled to raise interest rates to fight inflation. Most central banks have a mandate to maintain price stability. If an economy runs hot, price-push inflation (where too much money is chasing not enough goods) may see the costs of goods and services rise at a rate higher than the central bank’s policy mandate, usually around 2%.
The other type of inflation is wage-push inflation, where the hot economy compels employers to raise wages to entice workers to stay with them or to attract new workers. The wage increase can translate into increased consumer demand, resulting in a price-push scenario. In both cases, high or rising inflation may appear on the central bank’s radar screen, compelling them to raise interest rates to combat inflation.
When both inflation scenarios are in play, as they were in 2022 and most of 2023, central banks are forced to take extreme action on interest, raising rates.
Role of the Central Bank
Central banks practice countercyclical monetary policy, easing the money supply in recessions as economic activity and inflation slow and tightening it as necessary during recoveries.
The primary tools available to the Federal Reserve are its target federal funds rate range and balance sheet. And while those tools have an effect over time, they’re not instant remedies.
The target federal funds rate range governs the rates banks charge each other for reserves lent overnight. The Fed lowers the rate range to ease financial conditions at the margin, hoping that consumers and businesses begin borrowing again to stimulate the economy. It raises the rate range to tighten conditions and reduce spending.
Its balance sheet reflects the value of its assets, which it adjusts to control the amount of currency in circulation.
Quantitative Easing
Following the 2008 financial crisis, central banks in the United States, Europe, and Japan kept short-term interest near zero for years to contain downside risks to economic growth. When that proved insufficient, they engaged in large-scale asset purchases, also known as quantitative easing. The asset purchases increased the amount of money in circulation, giving banks more liquidity and the ability to issue more loans.
Additionally, demand for the assets—usually government bonds and Treasuries—purchased by the central bank increased, thereby raising coupon rates, which are the interest rates for fixed-income securities.
As expectations for a recovery begin to be reflected in inflation and asset prices, the central bank can raise its target rate and reduce its balance sheet by selling the assets it previously purchased.
2023: Recession With Increasing Interest Rates?
The years 2022 and 2023 bucked the usual trend a bit. High interest rates typically cause the economy to crash, after which interest rates are lowered to stimulate activity again. However, things have played out slightly differently during the COVID-19-induced economic downturn and the following recovery.
A popular rule of thumb is that two consecutive quarters of decline ingross domestic product (GDP) mark a recession, which would mean that the U.S. entered a recession in the summer of 2022. If that’s the case, then why, you might ask, have we seen interest rates and inflation continue to rise?
This suggests one of two things: Interest rates don’t necessarily fall during recessions, or we are not actually in a recession.
In many ways, we are in uncharted territory. The current situation was created from a combination of COVID-19, the war in Ukraine, the energy shock, and years of rock-bottom interest rates. It’s fair to say that these events aren’t normal.
Or maybe it would be wiser to question if we really are in a recession. Typically, during a recession, prices don’t rise, unemployment doesn’t sit at a five-decade low, and GDP doesn’t bounce back after just two quarters of decline—and then continue climbing.
Do Interest Rates Rise or Fall in a Recession?
Interest rates usually fall during a recession. Historically, the economy typically grows until interest rates are hiked to cool down price inflation and the soaring cost of living. Often, this results in a recession and a return to low interest rates to stimulate growth.
Are We Headed for a Recession in 2023?
Many economists, including The World Bank, predict a recession in 2023. However, there are no guarantees. The global economy has been flirting with recession since the outbreak of COVID-19. However, it is likely the widespread belief that a full-blown recession is looming that will push the economy into one.
Will Interest Rates Go Down in 2024?
We don’t know what will happen in the future. However, what we can generally say is that if the economy does spiral into a nasty recession in 2023, as some economists are predicting, it’s likely that interest rates will be reduced to spur borrowing, spending, and growth.
The Bottom Line
Interest rates usually fall in a recession, reflecting reduced credit demand, increased savings, and an investor flight to "safe" Treasuries. The decline also anticipates a central bank's likely response to the economic downturn, which can include cuts in short-term interest rates and large-scale asset purchases of debt securities with extended maturities.
Based on this logic, supported by decades of historical evidence, the dramatic increase in interest rates witnessed in 2022 and 2023 to cool down inflation may result in a recession—but it might not, as the U.S. and global economies are experiencing unfamiliar conditions.
