Warning of Economic Downturn as Interest Rates Rise

There is no other price in the economy that compares in significance to the price of money. It is possible to attribute the expansion and contraction of the business cycle to changes in interest rates. Rates on the market are a reflection of the demand for credit from borrowers and the supply of credit that is currently available; this, in turn, is a reflection of shifting preferences between saving and spending.

Key Takeaways

1. During a recession, interest rates almost always go down because the demand for loans goes down and investors seek safer investments.
2. During a period of economic instability, a central bank may choose to cut short-term interest rates and buy assets.
3. These actions have an effect on the economy both directly and indirectly because they signal the central bank’s intention to maintain accommodative monetary policy for a longer period of time.
4. When the economy shows signs of improvement, the central bank may decide to reverse some or all of those policies in an effort to control inflation.

Both the Supply and the Demand

The need for loans is often one of the first industries to feel the effects of a recession. As a result of the slowdown in economic activity, businesses shelve expansion plans that they had intended to finance with borrowings in the past. As layoffs become more widespread, consumers who are concerned about their jobs start spending less and saving more money.

It is also possible for lenders to pull back during a financial crisis, which would subject the economy to the additional pain of a credit crunch and force a central bank with the mandate to address such systemic threats to intervene in the market.

Therefore, if the yield on the 10-year Treasury note falls below that of the two-year Treasury note, for example, it is typically the case that investors are already anticipating economic weakness and opting for the longer-dated fixed-income maturities that tend to outperform in downturns. This is because longer-dated fixed-income maturities tend to be less volatile than shorter-dated fixed-income maturities.

The Crux of the Matter

When the economy is going through a recession, interest rates go down as a direct result of decreased demand for credit, increased savings, and a flight to safety into Treasuries. The decline also reflects an expectation of the likely response that a central bank will have to the current economic slowdown. This response may include reductions in short-term interest rates as well as large-scale asset purchases of debt securities with extended maturities.

Conclusion

Balanced growth is necessary for economic development, and this can be accomplished by simultaneously fostering expansion across all relevant sectors. The savings that people have are directed into investment channels with the help of the financial system. It helps in both the mobilisation of savings and the making of better use of these funds by allowing investments in a variety of different economic sectors. Tax increases during a period of economic contraction only serve to make people’s lives more difficult and compel them to spend even less money. As a result, one of the primary objectives of financial systems is to maintain economic stability. The primary responsibility of central banks is to either maintain economic steadiness or to restore economic balance in the event that economic conditions deteriorate.