When the economy is in recession, many consumers do not spend freely. The Federal Reserve may make adjustments to interest rates to encourage consumer confidence. The resulting change is passed on to lenders, who then use that adjusted rate to set their rates. During a recession, consumers may save more money than they have access to, which lowers the demand for credit. Consequently, the interest rate will increase to reflect this situation.
Generally, during a recession, interest rates fall. This is because the economy is weaker and people are taking out less credit. Savings have risen, which causes the interest rates to fall. Likewise, the Federal Reserve may raise rates during an expansionary period to suppress the demand for loans and prevent the economy from overheating. Recessions can result in an inverted yield curve. An inverted yield curve occurs when the yield on a longer Treasury note falls below its shorter counterpart. Longer fixed income maturities generally underperform in a downturn.
Whether or not a recession is inevitable is unclear. Many economists look to the past for clues as to when a recession might start. It is considered a recession if the economy experiences two consecutive quarters of negative GDP. A recession may last for months or even years, depending on the severity of the recession. When the economy starts recovering from a recession, the stock market typically rises and consumer confidence improves. Interest rates may go up once the economy is back in expansion mode.
During a recession, unemployment rates will rise and it will be harder to find a job. People who are lucky enough to retain a job will likely see pay cuts. Even those who keep their jobs will have trouble negotiating future pay raises. A recession also means lenders will tighten their standards. They will likely require a higher down payment or a better credit score. A recession is often a time to consolidate debts and save money.
The Fed has a good record of avoiding a recession through rate hikes, but this isn't always the case. In fact, nine out of 10 tightening cycles ended in recessions. Inflation has risen in the past year, and food and fuel prices have nearly doubled. As a result, housing prices have increased 12 to 16 percent. Inflation could be much worse if the Fed does not take measures to address the situation.
A sharp rise in real interest rates precedes periods of negative output growth. In the case of the United States, for example, real interest rates spiked in the fourth quarter of 1979 and increased by an additional three percentage points in 1980. At that time, real output fell for three quarters and a year later. While this may sound like a coincidence, the lag between a spike in interest rates and a recession begins months or years after it peaks.
