If you’re living in a time of rising inflation, you may hear about the Federal Reserve (or the Fed, for short) increasing interest rates. Inflation is essentially the devaluing of currency over time. If inflation happens too rapidly, people’s purchasing power decreases, and less money circulates into the economy.
Key takeaways
- A recession is when the economy experiences negative GDP growth and a slowdown in other areas.
- Interest rates typically fall once the economy is in a recession, as the Fed attempts to spur growth.
- Refinancing debt and making more significant purchases are ways to take advantage of lower interest rates.
Raising interest rates is one way the Fed attempts to combat this. When interest rates go up, people are less likely to borrow and spend, which can help drive down demand and prices. The Fed can reign in excessive growth by raising interest rates, which keeps money out of the economy.
The Fed also relies on interest rates when the economy enters a recession. In this article, we’ll explore what it means when the Fed lowers interest rates and discuss how you can take advantage of your increased borrowing power.
What is a Recession?
Let’s first make sure we understand what a recession is. Historically, economists define a recession as a period of prolonged economic decline. One rule of thumb for calling recessions is two consecutive quarters of negative gross domestic product growth (GDP) growth.
However, even if the economy experiences two negative quarters, the Federal Reserve may not call a recession. This is because the Fed considers more indicators than GDP and because they consider numbers relative to the monthly chronology. For example, if GDP declines only marginally in two quarters, the Fed may not call a recession as the decline was insignificant.
Other indicators, like unemployment and consumer spending, usually turn negative when GDP is negative. If these parts of the economy stay strong, the Fed may not declare a recession.
That said, a recession is not the end of the world. They’re a natural part of the economy and are usually swiftly followed by periods of growth. While recessions often cause pain due to job loss and decreased spending power, it’s possible to shore up your finances during a recessionary period, especially if you understand how lowered interest rates work.
What’s the difference between a recession and a depression?
A depression is a more severe and prolonged form of a recession. Typically marked by unemployment upwards of 20%, a depression would be apparent to everyone, whereas the Fed may take months to call a recession officially. Recessions, while very unpleasant, don’t involve as significant a decline in GDP sustained across many months as depressions.
There has only been one depression in U.S. history – the Great Depression – which stretched across the 1930s until the U.S. mobilized for World War II.
The Role of the Federal Reserve
The main job of the Federal Reserve is to keep inflation within a specific range. This target range is between 2-3% annually.
The Fed lowers interest rates when inflation falls below this target to spur economic growth. By lowering rates, the Fed also reduces the cost of borrowing. This allows businesses to borrow more cheaply and invest in growth projects. Investors, seeing this, are encouraged to buy stock. And at the same time, consumers everywhere can spend more money. This drives up demand, growing the economy.
When inflation is above the target range, the Fed raises interest rates. This slows the economy down by keeping businesses from borrowing lots of money. With a lower growth rate, investors turn away from stocks. Consumers borrow less and are likelier to put their money into savings accounts with higher yields. Less spending means lower demand, and the economy and inflation slowing down.
The Fed walks a thin line when dealing with inflation, as it needs to control it without driving the country into a recession. This is what’s referred to as a “soft landing.” In an ideal world, inflation would return to 2-3% annually, and the economy would continue to grow. Pulling off this balancing act is difficult, though, as the impact of raising interest rates doesn’t happen overnight. It takes time for the effects of higher rates to trickle through the economy.
Higher interest rates can slow inflation, but the effects may not be visible for months. Meanwhile, the Fed may continue to raise rates fearing inflation isn’t being curbed, possibly harming the economy.
Why Interest Rates Fall During a Recession
If the economy slows too much, it enters into a recession. With growth stalled and people losing their jobs, reduced incomes lead to people buying fewer goods and services. At this point, the Fed usually pivots and lowers interest rates to spur growth.
With lowered interest rates, businesses may rehire workers, and more people may borrow money. The economy will grow again if rates don’t fall too low, causing inflation to return and the Fed to crack down.
We’re trying to make the point that periods of growth and recession are in a constant tango with each other, and the Fed is trying to play catch-up.
Financial Moves to Make
So if interest rates go down because we enter a recession, how can you get ahead financially? Here are some options to consider.
Refinance Your Home
If you purchased a house last year, a recession could be the perfect time to refinance. Refinancing means revising an existing credit agreement to have new terms. You can lower your monthly payment with a lower interest rate, saving more money. A lower interest rate means you pay less interest overall. This can save you tens of thousands of dollars over the life of your mortgage.
If you bought your home before rates began rising, chances are you won’t be able to refinance yet, as interest rates will still be higher than when you purchased your home. A good rule of thumb is to refinance when you get more than a 1% reduction in the interest rate.
If you’ve been paying your mortgage for some time and choose to refinance, remember not to extend your mortgage back out to 30 years. If you do this, you will likely pay more in interest than if you hadn’t refinanced. In the first years of your mortgage, you mainly pay interest. If you are 14 years into your mortgage, your monthly payments are increasingly chipping away at the principal. By refinancing, you reset the clock.
If you refinance, try to switch to a term close to the years remaining on your loan or less. A refinance calculator can help you decide what makes the most sense.
Buy a House
There’s a chance that during a period of growth, you chose not to purchase a home because interest rates were too high. But if rates are suddenly low, now could be your time to buy. The added benefit of buying a house when rates are low is that most of the competition will have dried up. In other words, the seller’s market has become a buyer’s market.
Home prices tend to go down when fewer buyers are looking. This situation gives you more leverage when negotiating a price for a house. Make sure you take your time and only buy when you find the right home for you. If you find the right home but fear interest rates will drop further, fear not. You can always refinance to a lower rate. The priority should be finding the right house.
Consider Buying Bonds
Bonds tend to take a beating when the Fed aggressively raises interest rates. This is because bonds typically pay a fixed interest rate which becomes more attractive to investors if interest rates fall. By the same logic, investors usually avoid bonds during inflationary times when the Fed pushes interest rates up.
“Buying in” on bonds at the turn from an inflationary period to a recessionary period is smart because prices are low due to the recently high interest rates. As the Fed lowers interest rates again to push back against the recession and stimulate growth, bond prices will rise.
Invest in intermediate- and longer-term bonds, as these will have the higher rates locked in for a lengthy period. The interest rates on short-term bonds look attractive, but the new bonds will have a lower interest rate when they mature in a year or two. Your best option is to look long-term and enjoy the higher interest rate for the foreseeable future.
Buy a Car
You could also consider buying a car. People often have to take out loans to afford a car, so high interest rates can easily price you out for new or gently-used vehicles. In a recession, interest rates will decrease, and a good loan deal will be more in reach.
Some car manufacturers bring back special financing that can give you a remarkably low rate. During the recession, there are fewer car buyers as well. This means more inventory for you to choose from and less competition. You can negotiate a great price with your dealer and get a reasonable interest rate.
Final words
While a recession is not ideal, it is part of a healthy economic cycle. When the next one comes, as it inevitably will, keep in mind that interest rates will drop as the Fed works to encourage growth in the economy. Even if interest rates only drop slowly, as the Fed tries to avoid bringing back inflation, consider ways you can take advantage of cheaper borrowing. Refinancing your mortgage, buying a house, or purchasing bonds can all be savvy financial decisions.
