How Do Interest Rates Change During Economic Downturns?

Interest rates generally decrease during economic recessions due to a drop in loan demand, rising bond prices, and proactive monetary easing by central banks. In recent downturns, institutions like the Federal Reserve have lowered short-term rates and improved credit availability for public and corporate borrowers.

Key Insights

• Interest rates influence the economic cycle, reflecting the balance between borrowing demand and credit supply, which in turn is affected by shifts between saving and spending preferences.
• During recessions, rates usually decline as borrowing slows, investors seek safer assets, and consumer spending contracts.
• Central banks respond by reducing short-term interest rates and purchasing assets to encourage economic activity.
• These interventions not only impact the economy directly but also signal a commitment to maintaining accommodative monetary policies.
• When recovery begins, central banks may reverse these measures to control inflation and moderate growth.

Interest Rates and Market Forces

Loan demand often diminishes early in recessions. Businesses delay expansion plans that require financing, while consumers, concerned about job security, cut back on spending and increase saving.

Lenders might also restrict credit during financial crises, intensifying economic challenges and prompting central bank intervention to prevent systemic risks. Without such credit crunches, falling interest rates in recessions result from reduced borrowing demand and increased saving supply.

This pattern is often preceded by an inverted bond yield curve, where long-term Treasury yields fall below short-term yields, signaling investor expectations of economic slowdown.

Important Note

Economic growth typically thrives when borrowing costs are low, but central banks raise rates to cool inflation, which can lead to economic weakening.

Can Rising Interest Rates Trigger a Recession?

Central banks may increase interest rates to combat inflation, which arises when demand outpaces supply or when rising wages fuel consumer spending. Both scenarios can push prices beyond central bank targets, necessitating tighter monetary policy.

For example, during 2022 and much of 2023, inflation pressures forced central banks to raise rates significantly to stabilize prices.

The Central Bank's Role

Central banks use countercyclical monetary policies, expanding the money supply during recessions and tightening it during recoveries. The Federal Reserve primarily manages the federal funds rate and its balance sheet to influence economic conditions.

Lowering the federal funds rate encourages borrowing and spending, while raising it restricts credit to control inflation. Adjusting the balance sheet through asset purchases or sales affects currency circulation.

Quantitative Easing Explained

Post-2008, central banks maintained near-zero short-term rates and engaged in quantitative easing—large-scale asset purchases—to inject liquidity and promote lending. Buying government bonds increased demand, lowering yields and supporting economic recovery.

As economic conditions improve, central banks may raise rates and reduce their balance sheets by selling assets.

Do Interest Rates Rise or Fall in a Recession?

Interest rates typically fall during recessions. Historically, economies grow until central banks raise rates to curb inflation, which can lead to recessions followed by lower rates to stimulate growth.

Is a Recession Expected in 2025?

There is no certainty regarding a recession in 2025. The global economy has experienced ongoing challenges since the COVID-19 pandemic.

Will Interest Rates Decrease in 2026?

While future outcomes are uncertain, if a recession occurs in 2025, it is likely that interest rates will be lowered to encourage borrowing, spending, and economic expansion.

Conclusion

Interest rates generally decline during recessions due to lower borrowing demand, increased savings, and a flight to safe assets like government bonds. These trends often reflect anticipated central bank actions, including rate cuts and asset purchases aimed at supporting the economy through downturns.

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