Interest rates rarely increase during a recession. Actually, the opposite tends to happen; as the economy contracts, interest rates fall in tandem. Lowering the interest rates as an economy recedes is known as quantitive easing, and was widespread following the 2008 financial crisis.
Role of The Federal Reserve
The Federal Reserve has tools to control interest rates. During a recession, the Fed usually tries to coax rates downward to stimulate the economy. When a recession is on, people become skittish about borrowing money and are more apt to save what they have.
Following the basic demand curve, low demand for credit pushes the price of credit—meaning interest rates—downward.
The Fed knows how to use the fact that people save in a recession, and lower rates to a point where people think it might be stupid to not take advantage of such attractive rates. This is turn leads to an influx in loans, which pumps money back into the system and theoretically jumpstarts an economy.
The Federal Reserve exerts major influence on interest rates. It can push rates upward or downward by adjusting the federal funds rate, which is the interest rate at which banks lend money to each other to meet overnight reserve requirements, and by buying or selling Treasury bonds (T-bonds).
- Interest rates almost never rise during an economic slowdown, as it would deter capital from making its way back into the economy.
- Money is more tightly held during a slow economy, so interest rate controllers like the Federal Reserve make rates low as an incentive to reinvest in loans and purchases.
- It is possible to lower interest rates to negative, but that can do damage to an economy instead of jumpstarting it.
When a recession hits, the Federal Reserve prefers rates to be low. The prevailing logic is low-interest rates encourage borrowing and spending, which stimulates the economy.
A downside of this quantitative easing, or QE, is when countries keep interest rates too low—or even negative—for too long and the economy goes into stagnation, similar to when a car battery doesn't receive an adequate charge and bleeds power as a result. This is the most prevalent in some Eurozone countries in the period between 2008-2018, when the European central bank kept interest rates low for far longer than their bellwether, the United States Federal Reserve.
Supply and Demand
In a bad economy, consumers tend to become more fastidious with household finances. They are more careful about borrowing and more motivated to save the money left over after meeting expenses. This supply and demand dynamic creates an environment for low interest rates to thrive.
When everyone wants to borrow money, interest rates tend to rise; the high demand for credit means people are willing to pay more for it. During a recession, the opposite happens. No one wants credit, so the price of credit falls to entice borrowing activity.