During periods of economic expansion and contraction, interest rates are key components of the prevailing dynamic. They either directly or indirectly impact many facets of lending, business development and consumption. Accordingly, central banking authorities such as the United States Federal Reserve (FED), Reserve Bank of Australia (RBA) and European Central Bank (ECB) are tasked with regulating interest rates, thereby promoting pricing stability.
Interest Rate Valuations
An interest rate is the proportional amount of a loan that a lender charges for the use of its capital. Interest rates are calculated and applied in various periodic fashions, from daily to yearly.
The values of interest rates are determined in a multitude of ways, primarily through the open market or by the monetary policy of central banks. In the case of monetary policy, interbank lending rates assign the fees that banks charge one another to conduct business. Examples of such devices are the Federal Funds Target Rate established by the FED and the Bank Rate applied by the Bank of England (BoE).
In contrast to central-bank-defined interbank interest rates, open market interest rates are determined by the supply and demand of credit. Generally, as the demand for credit increases, so do interest rates. Open market rates impact the economy greatly via the cost of mortgages, revolving lines of corporate credit and unsecured consumer debt.
Interest Rates And Recessions
Interest rates are a valuable link between consumers, lenders, investors and savers. When credit markets are liquid and rates are stable, each is able to function normally. However, when credit markets become stressed as they did during the Global Financial Crisis of 2008, lending, consumption and economic growth grind to a halt. The results can be a severe recessionary cycle, widespread capital market tumult and dramatic central bank/governmental actions.
Central Banks And Recessions
The quintessential function of any central banking authority is to ensure pricing stability for its domestic economy. This concept is succinctly outlined by the BoE's official mission statement:
"Promote the good of the people of the United Kingdom by maintaining monetary and financial stability."
In practice, achieving monetary stability means to ensure that the prices of goods and services evolve in a normal manner. Accordingly, achieving financial stability requires that loanable funds are available to individuals, institutions and businesses deemed creditworthy. During times of economic expansion or recession, stability is promoted by central banks in two primary fashions:
- Interest rate adjustments: Interbank interest rates are adjusted to manage either inflationary or deflationary pressures. Typically, rates are increased during periods of economic expansion (inflation) and decreased in response to economic recession (deflation).
- Open Market Operations (OMO): Open market operations consist of the buying and selling of government-backed securities. Subsequently, when a central bank buys such securities, the money supply increases and open market interest rates go down. Upon a central bank selling government securities, capital is removed from the system, driving open market rates up.
A key facet of achieving pricing stability is to ensure that the money supply is at a state of relative equilibrium. This means that adequate credit must be available to borrowers and that an incentive to lend is present. To accomplish these tasks, central banks raise/lower interest rates and conduct open market operations according to prevailing economic conditions.
Recessions, Quantitative Easing And Falling Interest Rates
According to Forbes Magazine, a recession is commonly defined as being "a significant decline in economic activity that lasts for months or even years." Technically speaking, a recession is a contraction in GDP over two or more consecutive quarters. Recessions may be brought on by asset bubbles, heavy debt loads, extreme inflation/deflation or extraordinary events.
Dating back to the global recession of the early 2000s, the world's central banks have championed quantitative easing (QE) as a way of managing economic contraction. Essentially, QE is the combination of aggressive interest rate cuts and extensive open market operations. The goal of QE is to boost the money supply and increase credit market liquidity, thus meeting the demands of recessionary borrowers. Since 2000, extensive QE programs have been implemented by the FED, BoE, ECB and Bank of Japan (BoJ).
A prominent example of QE being used to combat recession was the central banking response to the novel coronavirus (COVID-19) outbreak of 2020. Amid the outbreak, interbank interest rates were quickly cut to near zero and unprecedented open market operations were rapidly conducted. Each function was designed to boost lending and consumption during the global economic shutdown.
Ultimately, recessions frequently lead to falling interest rates as central banks attempt to restore economic growth. To illustrate this point, below is look at the rock-bottom interbank rates adopted during the COVID-19 contagion (1 March 2020 to 1 July 2020):
- U.S., Federal Funds Rate: 0.25%
- U.K., Bank Rate: 0.10%
- Japan, Complementary Deposit Facility: -0.10%
- Canada, Policy Interest Rate: 0.25%
- E.U., Deposit Facility: -0.50%
To fight the economic fallout from COVID-19, interbank lending rates were reduced to historic lows. Although the long-term effects of such policy were debatable, the aggressive QE programs were credited with staving off a potentially catastrophic recessionary cycle.
As a general rule, interest rates fall during a recession. The primary driver of this phenomenon is the intervention of central banks via the implementation of QE policies. QE promotes credit market liquidity through furnishing lenders and consumers with affordable capital. In doing so, the demand for loanable funds is met, thus promoting growth and a possible end to the ongoing economic contraction.
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…