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.
- Interest rates usually fall in a recession as loan demand declines and investors seek safety.
- A central bank can lower short-term interest rates and buy assets during a downturn.
- Those actions affect the economy directly and by signaling 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 stem inflation.
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. 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.
So if the 10-year Treasury note's yield falls below that of the two-year Treasury note, for example, it typically happens because investors are already anticipating economic weakness and opting for the longer-dated fixed-income maturities that tend to outperform in downturns.
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.
When the Fed lowers the target fed funds rate, which is the rate banks charge each other for reserves lent overnight, it's easing financial conditions at the margin, and hoping the effect will spread throughout the economy. In fact, the transmission channels for this monetary policy may be blocked, as when low interest rates don't stimulate home purchases because many potential buyers can't get credit, for example.
Following the 2008 financial crisis, central banks in the U.S., 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.
The Bottom Line
Interest rates fall in a recession in a reflection of 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.