What Happens to Interest Rates During a Recession?

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.

No price in the economy is as important as the price of money. Interest rates arguably drive 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.

Supply and Demand

Loan demand can be an early casualty of a recession. As economic activity falters, companies shelve expansion plans that they otherwise would have financed with borrowings. Consumers worried about their jobs as layoffs spread 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 anticipates recessions, as shown by an inverted yield curve that frequently precedes 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.

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 single mandate to maintain price stability; i.e., fight inflation. If an economy is running 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, which is 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 increase in wages 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 try to combat inflation.

When both inflation scenarios are in play, as they are as of this writing, central banks are forced to take extreme action on interest, raising rates.

Role of the Central Bank

Central banks practice countercyclical monetary policy, easing 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 control of the federal funds rate and its balance sheet. And while those tools have an effect over time, they’re not instant remedies.

When the Fed lowers the target fed funds rate, which is the rate that banks charge each other for reserves lent overnight, it’s easing financial conditions at the margin and hoping that the effect will spread throughout the economy. In fact, the transmission channels for this monetary policy may be blocked—for example, when low interest rates don’t stimulate home purchases because many potential buyers can’t get credit.

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 serve to increase the demand for the assets bought—typically longer-term government or mortgage debt—thereby lowering yields, which are interest rates for fixed-income securities.

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

Because the central bank of a sovereign currency issuer has an unlimited supply of funds for asset purchases and short-term rate targeting, the signaling function can be particularly effective. As expectations for a recovery begin to be reflected in inflation and asset prices, the central bank can raise rates and reduce its balance sheet.

2022: Recession with Increasing Interest Rates?

The year 2022 has bucked the normal trend a bit. High interest rates normally cause the economy to crash, after which interest rates are lowered to stimulate activity again. However, during the COVID-19-induced economic downturn, things have played out slightly differently.  

A popular rule of thumb is that two consecutive quarters of decline in gross 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. Normally, 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. The previous GDP declines of 1.6% and 0.6% aren’t exactly massive drops, either.

Most economists agree that, as of November 2022, the economy is not yet in a recession, and that it will be interest rate increases, as normally is the case, that will eventually push us into one.

The Bottom Line

Interest rates usually fall in a recession, reflecting reduced credit demand, increased savings, and a flight to safety into 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, which is supported by decades of historical evidence, the dramatic increase in interest rates witnessed in 2022 to cool down inflation will likely eventually result in a recession, followed by a return to cheaper borrowing rates.