Interest rates play a key role in the economy and in the process of the economic cycle of expansion and recession. Market interest rates are the result of the interaction of the supply and demand for credit. They represent both the price of liquidity for businesses and the preferences for present versus future consumption by consumers and savers, and so they constitute a key link between on-paper finance and the real economic interests of households and individuals.

As such, interest rates are also a primary area of concern for economic policymakers and central banks—both in general and especially during challenging economic times.

What happens to interest rates during recessions is a product of the interplay between all of these forces, groups, and institutions. How this plays out in any given recession depends on the goals, choices, and actions of these players. In modern times, with central banking and fiat money as the universal norms, interest rates typically fall during recessions due to massive expansionary monetary policy.

Key Takeaways

  • Interest rates are a key link in the economy between investors and savers, as well as finance and real economic activity.
  • Markets for liquid credit function just like other types of markets, according to the laws of supply and demand.
  • When an economy enters a recession, demand for liquidity increases while the supply of credit decreases, which would normally be expected to result in an increase in interest rates. 
  • A central bank can use monetary policy to counteract the normal forces of supply and demand to reduce interest rates, which is why we see falling interest rates during recessions. 

Supply and Demand

Market interest rates are determined by the supply and demand for loanable funds. Businesses demand credit to finance new investments and ongoing operations. Consumers also demand credit for new purchases and to finance their expenses against their income on a revolving basis. These funds can be provided out of household savings or new credit created by banks. The market for loanable funds behaves in many ways similar to any other market where changes in supply and demand change the price—in this case, the interest rate.

Credit Crunch

The onset of a recession is usually marked by a credit crunch—an increase in demand for borrowing but a decrease in willingness to lend.

At the onset of a recession, there is an increase in demand for liquidity—usually across the board. Businesses rely on credit to cover their operations in the face of falling sales, consumers run up credit cards or other sources of credit to make up for the loss of income. There's a decrease in supply at the same time, as banks curtail lending. They do this to increase reserves as a way to cover losses on loan defaults and as households draw down savings to cover living expenses when their jobs and other income dry up.

Just like any good in a market, when demand increases and supply decreases, prices rise sharply. So the normal expectation would be for interest rates to rise as the recession begins.

Role of the Central Bank

A central bank, such as the U.S. Federal Reserve, has the ability to influence interest rates by buying and selling debt instruments and increasing or decreasing the supply of credit in the economy. During a recession, the Fed usually tries to coax rates downward to bail out borrowers—especially banks—and stimulate the economy by increasing the supply of credit available.

The Fed buys bonds, usually U.S. Treasury bonds or similarly high quality, low-risk bonds. In doing so, it injects an equivalent quantity of new reserves into the banking system, which supplies banks with fresh liquidity and directly lowers the federal funds rate—the rate at which banks loan each other money to meet immediate liquidity needs. This, in turn, leads to an influx in new lending, which lowers interest rates and supplies businesses and individuals with the loans they need to finance purchases and continue normal operations.

The federal funds rate—the interest financial institutions pay for overnight borrowing—has a direct impact on the prime rate, which is the interest rate that banks charge their best customers.

The end result is that the central bank’s expansion of the supply of credit counteracts the market forces of supply and demand, and interest rates for businesses and consumers fall during the recession. Although the newly created credit extends a lifeline to debt-dependent businesses and borrowers, it has other effects as well.

Monetary Policy, Interest Rates, and the Real Economy

Central bank monetary policy is an attempt to do an end-run around supply and demand, but as with other government policies, it comes with unintended consequences.

Firstly, the lower market interest rates discourage saving, hurting savers who now receive a lower return in exchange for forgoing their own consumption for the present. Secondly, because this means that less saving occurs, the resale resources that saving frees up for investment under normal conditions don’t materialize. 

The central bank’s newly created credit encourages both businesses to use more resources in their investment projects and consumers to simultaneously consume more resources. In the long run, this can cause additional problems in the economy such as inflation. It could even sow the seeds for a future recession.