How increasing interest rates could reduce inflation, but potentially cause a recession (2024)

FAQs

How increasing interest rates could reduce inflation, but potentially cause a recession? ›

“Raising interest rates helps to reduce the overall level of demand and therefore, hopefully, reduces the upward pressure on prices,” says Gapen. So why might this cause a recession? In the long run, businesses may respond to consumers purchasing fewer goods and services by reducing production, explains Gapen.

Whenever the Federal Reserve lifts rates to battle high inflation, the risk of a recession increases, and the US economy has typically fallen into an economic downturn under the weight of rising borrowing costs.

Higher interest rates help to slow down price rises (inflation). That's because they reduce how much is spent across the UK. Experience tells us that when overall spending is lower, prices stop rising so quickly and inflation slows down.

Inflation and recessions are very different economic phenomena, but they are intrinsically linked. High inflation rates can indicate an impending recession, as businesses react to higher costs by reducing production and increasing prices.

Interest rates usually fall in a recession as loan demand declines, investors seek safety, and consumers reduce spending. A central bank can lower short-term interest rates and buy assets during a downturn to stimulate spending.

Many investors use the spread between the yields on 10-year and two-year U.S. Treasury bonds as a yield curve proxy and a relatively reliable leading indicator of a recession. Some Federal Reserve officials have argued that a focus on shorter-term maturities is more informative about the likelihood of a recession.

Higher interest rates force consumers to cut back on spending. Banks toughen their standards as well, making fewer loans. Inevitably, this affects the bottom line of many businesses.

How does the Fed control inflation? The Federal Reserve seeks to control inflation by influencing interest rates. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down.

When interest rates rise it's also more expensive for businesses to borrow money. This often means less growth and lower profit expectations. In theory, this should lower the share price of a company.

As interest rates on U.S. Treasury securities rise, so too will the federal government's borrowing costs. The United States was able to borrow cheaply to respond to the pandemic because interest rates were historically low.

Which is worse, recession or inflation? ›

“If your job is recession-proof, inflation will be worse for you,” Lieberman said. “In some fields, such as plumbing or healthcare, people can't cut back when those needs arise. So you won't feel the effects of a recession as much as you would inflation.

In economics, stagflation (or recession-inflation) is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high.

High Interest Rates

The Fed issued its most recent rate hike in July 2023. Higher interest rates increase the cost of borrowing money, discouraging companies from taking on debt to invest in expansion. Higher rates also reduce consumer spending, easing demand pressures that contribute to rising prices.

Increasing the bank rate is like a lever for slowing down inflation. By raising it, people should, in theory, start to save more and borrow less, which will push down demand for goods and services and lead to lower prices.

The financial crash and global recession of 2008 was "the worst economic disaster since the Great Depression of 1929", according to The Balance. The crash was triggered primarily by the collapse of the U.S. Housing Market, according to Investopedia.

Your money will not be lost. It is usually transferred to another bank with FDIC insurance, or you'll receive a check.

Higher interest rates can make borrowing money more expensive for consumers and businesses, while also potentially making it harder to get approved for loans. On the positive side, higher interest rates can benefit savers as banks increase yields to attract more deposits.

Three of the most evident are: They increase the cost of borrowing for individuals, potentially reducing spending; they increase the cost of borrowing for businesses, potentially reducing investment; and they can tighten the money supply, which can reduce inflation.

Rates drops are more common in the early stages of a recession. As the economy begins to pick up, the Federal Reserve may adjust its interest rate policy. Once the economy begins to approach the peak of an expansion period, the Fed may raise rates in order to curb borrowing and spending.

As corporations and households get overextended and face difficulties in meeting their debt obligations, they reduce investment and consumption, which in turn leads to a decrease in economic activity. Not all such credit booms end up in recessions, but when they do, these recessions are often more costly than others.