What’s the Link Between Federal Interest Rate Policy and Recession?

by | May 13, 2020 | Uncategorized

On March 15, 2020, the Federal Reserve announced that it was cutting its benchmark interest rate to 0%. The decision was made as the government moves to offset the economic fallout caused by the novel Coronavirus and its spread in the United States.

Goldman Sachs has estimated that the economy could contract by 24% in the second quarter. In the current quarter, the decline is estimated close to 5%.

Anyone wanting to understand the relationship between Federal interest rate policy and recessions will gain some important insights from the following data.

A Modern History of America’s Recessions

The first major shock to the world economy after World War II was the 1973 -1975 Recession. This affected America and most of the developed world.

During this recession, the Federal Reserve was highly active, and rates were higher than we are used to today. In August of 1974, with the recession in full swing, the Federal Funds Rate was as high as 12.35%. It had been climbing from a rate of 9.83% at the beginning of that year. The Fed began to drop the rate, having it fall as low as 4.93% in May 1975. In this case, we see that the rate was climbing ahead of the recession, before peaking and declining to support economic growth.

The next major shock was the 2008 Great Recession. It followed the stock market’s all-time peak in 2007.

In September 2007, The Federal Funds Rate was sitting at 5.25%, an increase from 4.96% at the start of that year. The Fed began to drop the rate in response to economic decline. By the end of 2008, it was sitting at 0.1%. The recession peaked in 2009, but rates increased slowly. The Federal Funds Rate didn’t break 1% until 2017.

What Parallels Can We Draw to the Situation Today?

In modern history, rates have decreased during recessions, but not in the leadup. The Fed is mostly responsive. It reacts to market conditions and lowers rates to incentivize borrowing and spending.

Today’s situation is unique. Until last week, the Fed had been cautiously lowering the rate to prolong a sustained period of economic expansion. It now has little leverage, and economies of major cities and the entire state of California have effectively shut down.

This will be a moment in history not only for how the world deals with a viral pandemic but also for how quickly the economy can bounce back. Today’s rate may shorten the length of economic decline. Unfortunately, the wildcard of the ongoing health crisis makes it impossible to predict the duration or severity of what will happen in the coming months.