You may be familiar with the concept of quantitative easing – the fancy term for central banks like the U.S. Federal Reserve cutting interest rates. Interest rates have a tendency to decrease during a recession because central banks in many nations cut rates in an attempt to stimulate lending and economic expansion. Lower rates incentivize borrowing and spending by companies and consumers alike. Companies can take out more loans to help them grow and expand and consumers can buy big-ticket items like houses, cars, etc., that require loans for less.
But what are the implications for your current business’s loans? On the surface, typically changing interest rates should not impact your loan if you have a fixed interest rate. Whereas, if you have a variable rate, your rate will likely change. However, there is more nuance to it than this. In this article, we’ll dive into the details of the nuances.
The way in which the shift affects you will be determined by a number of different circumstances, such as the extent to which the recession has had an effect on your personal finances and whether or not you are attempting to save money or borrow money.
Here is what we will cover in this article:
What Exactly is a Recession?
When an economic recession takes place, there is often a broad and sustained decrease in economic activity. On the other hand, the precise measurement and definition of a recession might be subjective.
When there are 2 consecutive quarters of negative gross domestic product (GDP) growth, the economy is said to be in a recession, according to one definition of the term.
A more sophisticated method is used, however, by the nonprofit National Bureau of Economic Research (NBER), which is responsible for determining the beginning and ending dates of recessions in the United States.
The National Bureau of Economic Research and economists take into account a variety of other indicators in addition to GDP figures, including income and unemployment rates.
The National Bureau of Economic Research (NBER) validated in June that the current recession in the US economy started in February of 2022. The economy will transition out of recession and into growth once it reaches its lowest point.
What Kind of Effect Do Recessions Have on Interest Rates?
When the economy is experiencing a downturn, governments often take measures to stabilize the situation and boost growth, which might result in a decrease in interest rates.
It may take many months to collect all of the data that is necessary to identify when a recession begins. Nonetheless, the Federal Reserve of the United States lowered its target interest rate in the middle of March 2020 in reaction to the economic effect of the coronavirus epidemic.
Recently though, due to mounting inflation, the Federal Reserve has been hiking interest rates aggressively. This is typically not seen during recessionary periods; however, the United States economy is in a very unique situation right now, with high inflation and slowing GDP growth after negative growth in the first and second quarters of 2022. However, the United States is also experiencing low unemployment, which is typically not the case as economies transition into a recession. Economists continue to debate what the short-term future of the U.S. economy will entail.
Regardless, under normal recessionary circumstances, low-interest rates make it more affordable to borrow money while simultaneously making it less beneficial to save money, which may boost consumer and business spending. This is because businesses can get loans in order to make investments in their operations, and individuals will find it less advantageous to save money with low-interest rates. Instead, they will likely invest their money or use it to buy big-ticket items.
For instance, a greater number of individuals may be enticed to purchase a new automobile when the interest rate on auto loans is cheap. This higher demand helps to sustain the activity that goes into making and selling the car and boosts the economy at large. On account of these added purchases, the company can keep more employees on the payroll, who will then be able to spend more themselves in the economy. It’s all very cyclical and intertwined.
Nevertheless, you could discover that it is challenging to obtain authorization for a small business loan during a recession since creditors become hesitant about providing money at this time. They could need a higher minimum credit score on your credit card, a larger down payment, or even cease giving certain kinds of loans entirely if they decide to take any of these actions.
How Will the U.S. Federal Reserve Respond to a Recession?
The Federal Reserve, which is the central bank of the United States, has a twin mandate: one is to work toward achieving low unemployment, and the other is to work toward maintaining stable prices with cash flow across the economy (i.e. they have to keep the inflation rate at a reasonable level).
A traditional recession is characterized by an increase in unemployment as well as a process known as deflation in which prices sometimes decrease.
Both in order to fulfill its mandate and in order to provide emergency support to the financial system and the economy of the United States, the Federal Reserve may take drastic measures to reduce unemployment and boost prices in the event that the economy experiences a severe downturn.
At the beginning of a recession, businesses start to see a drop in earnings, and some may even be forced to cease operations (i.e. go bankrupt). This is typically the result of a combination of real economic shocks and economic bottlenecks, which are brought on by the incompatibility of production and consumption activities as a direct consequence of previously distorted interest rates and credit conditions.
There are a lot of layoffs, and small business owners often get rid of their employees, liquidate their assets, and occasionally even fail on their repayment of loans or declare bankruptcy.
All of these factors exert downward pressure on pricing and the availability of credit to firms in general, which has the potential to kickstart a process known as debt deflation.
The Federal Reserve will not shy away from taking decisive action in the interest of maintaining stability if it means preventing the member banks of its system from defaulting on the excessive debts they have incurred.
In order to achieve these objectives, the Federal Reserve might use a variety of policy measures to try to stimulate economic activity during a period of economic contraction. These tools may be divided up into four distinct groups, each of which will be discussed in more detail below:
Open Market Operations
By purchasing debt securities on the open market in exchange for freshly issued bank credit, the Federal Reserve is able to bring down overall higher interest rates. When banks receive this additional credit, they are able to lend some of it out to other banks in the system. As a result, the banks that the Federal Reserve buys reserves from are therefore able to reduce the fed funds rate, which is the interest rate at which they lend money to each other overnight since they are flush with fresh reserves. The idea is this then works its way through the banking system, such that it eventually impact the loans made to businesses and consumers. This added liquidity in the banking sector helps lower interest rates as the supply of loanable funds increases. In essence, the Federal Reserve is making a bet that a reduction in interest rates will have a ripple effect across the whole financial system, resulting in lower rates for both consumers and companies.
When this strategy is successful, the reduced interest rates make it cheaper for businesses to borrow money, which enables them to continue incurring more debt rather than falling into default or being forced to let employees go without pay.
When a recession occurs, this helps workers stay in their present occupations and suppresses the growth in the number of people looking for work.
There are occasions when banks just hang on to the freshly injected reserve credit for their own use as liquid reserves against their debt commitments, which prevents the interest rates from falling any further. In situations like these, the Federal Reserve may decide to simply go on with its open market operations, which include the purchasing of bonds and other assets, in order to inundate the banking system with fresh credit until the banks eventually begin adjusting the interest rates.
This practice is referred to as quantitative easing or QE, and it refers to the direct purchase of assets by the Federal Reserve in order to infuse more money into the economy and grow the money supply.
Reducing the Need for Initial Investment
The Fed is also able to supervise financial institutions to guarantee that they are not forced to have capital on hand to cover the possibility of debt redemption.
Historically, it was the Fed’s job to regulate the banking industry and make sure that financial institutions had sufficient liquid reserves so that they could fulfill redemption requests and stay in business.
The Federal Reserve might relax some of its standards during economic downturns, giving financial institutions more leeway to reduce their reserves but running the danger of making the institutions more susceptible to financial shocks. When banks can reduce their reserves, they are able to make more loans. This again increases the supply of loanable funds and, in theory, lowers interest rates.
However, as a consequence of the Federal Reserve’s policy of quantitative easing in the aftermath of the financial crisis of 2007–2008, banks have been keeping enormous continuous amounts of reserves that are in excess of the statutory reserve ratio. This has made this a less effective policy tool for the Federal Reserve in recent years. Indeed, the Federal Reserve decided in March 2020 to do away with all reserve requirements for banks. As a result, the Federal Reserve is now only capable of tightening credit restrictions, since they have already been eased as much as possible.
Discount Window Lending
Through what is known as the discount window, the Fed has the ability to directly lend cash to banks that are in need of such assistance.
Given the precarious nature of the loans, historically, this kind of lending was done as an emergency bailout loan of last resort for banks that were out of other options. In essence, banks were forced to pursue all other alternatives before borrowing with the discount window. This changed in 2003 when the process was redesigned and the discount window lending rate was set above the federal funds rate, therefore removing the attractiveness of discount window loans. This was then redesigned again after the 2007-2009 financial crisis.
In order to provide exceptionally advantageous conditions to borrowers with the highest levels of risk, the Federal Reserve lowered its discount rate to a record low of 0.25% in March 2020 due to the pandemic. The discount rate, however, was brought back up to 4% by November 2022 as a result of a string of aggressive rate hikes that the Federal Reserve had implemented to combat excessive inflation.
Banks themselves often try to avoid utilizing these loans because of the stigma associated with them. Because the Federal Reserve is seen as a lender of last resort for banks, there is concern by banks that borrowing from the Fed will signal to the market that they are having issues.
The process of managing expectations is often referred to as forward guidance. The Federal Reserve is aware of the significance of the role that market expectations play not just in the financial sector but also in the economy and working capital, as shown by a significant portion of the economic research and theory on financial markets and asset prices.
On top of issues now confronting the economy is pessimism among investors, banks, and companies. This oftentimes can be caused by uncertainty over the Federal Reserve’s plans for the future.
The best example of how powerful the Fed’s role in setting expectations is can be seen by the recent stock market fluctuations. Many of these large fluctuations have been in response to Fed meetings, where they have at times informed the public of their intent to continue raising interest rates while changing how aggressively they plan to do so.
Fighting Inflation While Keeping an Eye on the Threat of a Recession
The phenomenon known as inflation takes place when general price levels in the economy go up while at the same time the buying power of the dollar goes down.
During times of economic contraction, inflation may actually stay far lower than the Fed’s objective of around 2% per year, which enables the Fed to keep its accommodative monetary policy in place. The Fed’s inflation target is approximately 2% per year.
On the other hand, an expansionary monetary policy has the potential to ultimately cause inflation.
If the economy is running at or near its maximum potential, there are not enough employees to fill all of the positions that are available, or if salaries are growing at a higher rate than the rise of productivity, then more people will want to borrow money to finance greater spending.
The supply of labor will not expand rapidly enough to satisfy the growing demand for labor, which will result in rising salaries compared to the rise of productivity as well as a wage-price spiral in which companies will be pushed to boost wages to match the cost of borrowing money.
The fact that people and businesses have access to affordable credit may also contribute to a rise in borrowing, spending, and investment, all of which have the potential to lead to both stronger economic growth and higher pricing. When taken together, these elements have the potential to bring about inflationary price increases in the economy’s assets.
During times of high inflation, central banks are required to fight price pressures in a vigorous manner by increasing interest rates and/or executing contractionary policies such as increasing bank reserve requirements or selling off assets.
This is done in order to combat high inflation. When inflation remains over the target level for an extended period of time, it has the potential to drive the economy into a state known as stagflation, which is characterized by simultaneously high rates of unemployment and inflation.
This twofold dilemma is unsustainable for the central bank, and the only way it can be resolved is for the central bank to aggressively tighten monetary policy in order to reduce pricing pressures and cut aggregate demand in the economy. Nevertheless, this has the potential to bring on yet another recession.
As of the beginning of 2022, the Federal Reserve has been put in the position of having to deal with exactly this kind of situation, since inflation rates have risen to levels that have not been seen since the early 1980s, while signs of a recession have been mounting (some would consider the two contractionary quarters at the beginning of 2022 a mini recession).
As a direct reaction, the Federal Reserve has been hiking interest rates at a breakneck speed in an effort to curb rising prices. While there are many who believe the Federal Reserve has not been forceful enough, there are others who believe that further rises in interest rates might lead to a downturn in the economy.
What Will Happen to Business Loans During a Recession?
What happens to business loans during a recession all depends on what happens to the interest rate. If the economy enters a state of stagflation, then unlike with most recessions, interest rates will have to be hiked aggressively (similar to the current state of the U.S. economy). This means business loans will follow suit. Since small business lending is inherently risky compared to some other forms of lending, these loans can become very costly. We have seen business loan interest rates climb aggressively as of late on account of the Federal Reserve raising interest rates.
This is one of the main reasons that businesses have to be careful about taking on variable interest rate business loans. With a variable interest rate, your rate can increase dramatically on account of economic conditions that are out of your control.
Locking in a long-term rate tends to be much safer. Plus, if rates fall, you can always refinance your loan to take advantage of the lower interest rates.
What Types of Loans Have Variable Interest Rates?
There are so many different loan options and combinations these days that essentially any type of business loan could theoretically have a variable interest rate attached to it. That is why it is important that you understand the entirety of the terms and conditions of a loan before agreeing to one. However, here are some common loans that can have variable interest rates:
- SBA 7(a) loans – SBA 7(a) loans are very popular for small business owners. They can have fixed OR variable interest rates. If your SBA 7(a) loan has a variable interest rate, then economic conditions will impact the overall cost of your loan in the long run.
- Lines of Credit – Lines of credit have variable interest rates because they are always available for the business to tap into. As a result, they typically fluctuate based on the given prime rate plus some sort of premium on top of it.
- Credit Cards – Credit cards also have variable interest rates, and the rates are usually very high. Credit cards typically should be avoided for long-term financing.
The list goes on since, as noted, just about any loan can have a variable interest rate attached to it.
Should I Refinance My Loans When the Economy Is in a Downturn?
As noted, an economy in a downturn can be a great opportunity to refinance your loans if the conditions are right. But it ultimately comes down to your individual situation, the cost of refinancing, and whether interest rates are actually falling. If you are able to be approved for a new loan, refinancing your loans while interest rates are low might help you save money and reduce the amount you pay each month for your obligations.
During economic downturns, the Fed makes it a general practice to try to credibly reassure financial institutions through its actions and public announcements that it will take measures to prevent or cushion its member banks and the broader financial system from suffering losses that are excessively severe. The actions they take have broad ramifications for all Americans, particularly small business owners who tend to rely more on being able to borrow than most everyday workers.
Overall, recessions will tend to impact your business’s future borrowing capabilities as the interest rates change. However, if you have fixed rate loans, you won’t have to worry about the interest rates changing on them. Instead, your number one concern will be ensuring that you are able to service the interest payments on the loan during the recessionary period since oftentimes small businesses will see a decrease in revenues, profits, and cash flow on account of declining economic conditions. However, you likely will not have to worry about the interest rates on your outstanding business loans themselves being impacted unless you have variable interest rates.
At Biz2Credit, we work tirelessly to be a leading supporter of the small business community in the United States. As part of this, we post new content each day on our Biz2Credit Blog. So, please continue to check back here for the latest news, information, and trends impacting small businesses across the nation.