How the Federal Reserve Fights Recessions (2024)

The U.S. central bank, the Federal Reserve, has a dual mandate: to work to achieve low unemployment, and to maintain stable prices throughout the economy. During a recession, unemployment rises, and prices sometimes fall in a process known as deflation.

The Fed, in the case of steep economic downturns, may take dramatic steps to suppress unemployment and bolster prices, both to fulfill its traditional mandate and to provide emergency support to the U.S. financial system and economy.

At the onset of a recession, some businesses begin to fail, typically due to some combination of real economic shocks or economic bottlenecks caused by the incompatibility of production and consumption activities resulting from previously distorted interest rate and credit conditions. These businesses lay off workers, sell assets, and sometimes default on their debts or even go bankrupt. All these things put downward pressure on prices and the supply of credit to businesses in general, which can spark a process of debt deflation.

Deflation, in the form of falling prices, is not generally a harmful process for the economy or a problem for most businesses and consumers by itself. It is, however, widely feared by central banks and the broader financial sector, especially when it involves debt deflation because it increases the real value of debts and thus the risk to debtors. Banks and related institutions are typically among the largest debtors in any modern economy. To protect its constituent banks from defaulting on their overextended debts, the Federal Reserve does not hesitate to take action in the name of stability.

The Federal Reserve has a number of tools to attempt to reinflate the economy during a recession in pursuit of these goals. These tools largely fall into four categories, which we will look at below.

Open Market Operations

The Fed can lower interest rates by buying debt securities on the open market in return for newly created bank credit. Flush with new reserves, the banks that the Fed buys from are able to lend money to each other at a lower federal funds rate, the rate at which banks lend to each other overnight. The Fed hopes that a drop in interest rates spreads throughout the financial system, reducing rates charged to businesses and individuals.

When this works, the lower rates make it cheaper for companies to borrow, allowing them to continue going into more debt rather than defaulting or being forced to lay off staff. This helps to both keep employees in their current jobs and suppress the rise in unemployment when a recession hits. Lower interest rates also enable consumers to make more purchases on credit, keeping consumer prices high and likewise extending themselves further into debt rather than live within their means.

There are times when interest rates won’t go any lower because banks simply hold on to the newly injected reserve credit for their own use as liquid reserves against their debt obligations. In these cases, the Federal Reserve may choose to simply continue open market operations, buying bonds and other assets to flood the banking system with new credit. This is known as quantitative easing (QE)—the direct purchase of assets by the Federal Reserve to inject more money into the economy and expand the money supply.

The Fed has used quantitative easing on several occasions since 2008, including in March 2020, when the central bank launched an initial $700 billion QE plan aimed at propping up the debts of the financial system on top of most of the nearly $4 trillion in quantitative easing that it created during the Great Recession.

Lowering Capital Requirements

The Fed also can regulate banks to ensure that they are not required to hold capital against potential debt redemption. Historically, the Fed was charged with regulating the banks to make sure they maintained adequate liquid reserves to meet redemption demands and remain solvent. During recessions, the Fed could also lower requirements to allow banks greater flexibility to run their reserves down, at the risk that this may increase banks’ financial vulnerability.

However, after the 2007–08 financial crisis, the Fed’s campaign of quantitative easing resulted in banks holding massive ongoing balances of reserves in excess of the required reserve ratio. In part because of this, as of March 2020, the Fed eliminated all reserve requirements for banks. This leaves the Fed no further room to use this tool to loosen credit conditions for the impending recession.

Discount Lending

The Fed can directly lend funds to banks in need through what is called the discount window. Historically, this type of lending was carried out as an emergency bailout loan of last resort for banks out of other options—and it came with a hefty interest rate to protect the interests of taxpayers, given the risky nature of the loans.

However, in recent decades, the practice of discount lending by the Fed has shifted toward making these risky loans at much lower interest rates to favor the interests of the financial sector as much as possible. It has also rolled out a host of new lending facilities similar to discount lending, targeted at supporting specific sectors of the economy or the prices of specific asset classes.

As of March 2020, the Fed dropped its discount rate to a record low 0.25% to give extraordinarily favorable terms to the riskiest of borrowers. However, by November 2022, a series of assertive rate increases enacted by the Fed to cool high inflation had returned the discount rate to 4%.

Expectations Management

Expectations management is also known as forward guidance. Much of the economic research and theory on financial markets and asset prices acknowledge the role that market expectations play in the financial sector and the economy more broadly, and this is not lost on the Fed. Doubt as to whether the Fed will act to bail out banks and keep asset prices inflated can lead to pessimism among investors, banks, and businesses on top of the real problems facing the economy.

Fighting Inflation and the Specter of Recession

Inflation occurs when prices rise in the economy and the purchasing power of the dollar erodes. The Fed targets around 2% inflation per year, and during periods of recession, inflation may indeed remain well below this target, allowing the central bank to maintain expansionary monetary policy.

However, expansionary monetary policy also can eventually lead to inflation. If the economy is operating near capacity and there are not enough workers to fill all the jobs available, or if wages are rising faster than productivity growth, then more people will want to borrow money to fund additional consumption.

The supply of labor will not expand quickly enough to accommodate the increased demand for labor, leading to rising wages relative to productivity growth and a wage-price spiral in which firms are forced to raise wages to match the cost of borrowing. The availability of cheap credit to individuals and firms may also lead to increased borrowing, spending, and investing, which can lead to both economic growth and higher prices. These factors, when combined, can cause an inflationary rise in asset prices in the economy.

In periods of high inflation, central banks must aggressively fight price pressures by raising interest rates and/or implementing contractionary policies such as reducing bank reserve requirements or selling off assets. When inflation rises above the target level for too long, this can push the economy into stagflation, a situation in which high unemployment and high inflation occur at the same time.

This dual problem is untenable for the central bank, which can end it only by tightening policy aggressively to bring price pressures down and slash aggregate demand in the economy. This, however, can trigger another recession.

In 2022, the Fed is faced with just this type of scenario, as inflation rates rise to levels not seen since the early 1980s. In response, the Fed has raised interest rates at a rapid pace to cool prices. While some argue that the Fed has not been aggressive enough, others suggest that additional increases in rates could tip the economy into a contraction.

The Bottom Line

During recessions, the Fed generally seeks to credibly reassure market participants through its actions and public announcements that it will prevent or cushion its member banks and the financial system from suffering too-heavy losses, using the tools discussed above.