In the previous article, I explained how the Inverted Yield curve can indicate an upcoming recession. To read that article click here
https://www.mintpaisa.com/inverted-yield-curve/ .Now let us see what is the relationship between Recession and Interest Rates and this can be understood with the help following two topics
- How an increase in interest rate affect the economy of the country?
- What is the role of interest rates in the formation of the Inverted Yield curve?
But before that, let me give a brief about Inflation and Deflation so that it helps you to understand this article easily. Let’s get started
Increase in the costs of the goods and services and a decrease in the purchasing power of money.
The Decrease in the price of goods and services and an increase in the purchasing power of money.
How an increase in interest rate affect the economy of the country?
Federal Reserve Bank controls the interest rates. If the Fed increases the interest rates, then it will be difficult for commercial banks to take the loan from Reserve Bank. The rate at which the reserve bank lends out money to commercial banks is called Repo Rate.
Due to increased repo rate commercial banks are taking loans with the high-interest rate from reserve bank. This forces the commercial banks to raise their interest rate to its customers and industries.
Due to more interest rate, customers will stop taking loans, decrease their spending and starts saving their money. Also, the amount of loan applied by the companies also decreases as they have to pay more interest to the bank. This affects the company operations and reduces its growth. This happens with all the companies and runs them into the loss, which results in the fall in the share values and ultimately affecting share market which is an important indicator of the economy.
What is the role of interest rates in the formation of the Inverted Yield curve?
If the Fed raises the interest rates, the short bond offers more interest to the investors when compared to long term bonds. So the investors sell the long term bonds i.e., 10 Year bonds and start buying the short bonds like Treasury bills, 2 Year bonds because of high returns and less maturity. This raises the short term yield curve above the long term yield curve resulting in the formation of the Inverted Yield Curve.
But Why the Fed Raises Interest Rates?
Due to less interest rate offered by commercial banks, people tend to take more loans. This will increase the more currency circulation in the country which is the main cause of Inflation. It decreases the value of money.
Because people have more money in their pockets their spending on goods also increases. This makes the companies increase the price of goods to maintain the balance between supply and demand.
Till the mid 20 century, all countries used to follow gold standards that mean the currency circulation in the country depends on the country gold reserves. But in the modern world value of money depend on its circulation in the country. To control all the above possible scenarios reserve bank raises interest rates to control the inflation. You can read more here https://www.mintpaisa.com/money-vs-currency/
- Increase in the Fed interest means it increased the repo rate.
- Increase in repo rate force commercial banks to increase their interest rate on their customers.
- Companies stop or reduce the amount of loan they take usually because of high interest rates.
- This decrease in the slow down of the companies growth and profits which ultimately affects sharemarket. This also leads to the loss of many jobs.
Plungein Stockmarket pushes the country into a recession mode.
- These resulted in the formation of Relationship between the Recession and Interest Rates.