With rising interest rates, soaring inflation and a looming energy crisis, many are wondering whether we are already in a recession or are about to enter one. In this article we’ll explain what defines a recession, its causes, and how you can best prepare yourself.
What Is a Recession?
While there is no universally accepted definition of a recession, the most standard indicator of a recession is a decline in Gross Domestic Product (GDP) for two consecutive quarters. In other words, when the value of all the goods and services produced in a country has fallen for six straight months.
The National Bureau of Economic Research (NBER) tracks the start and finish of each US recession. It has a broader definition that uses employment, income, sales, and industrial production data in addition to GDP. NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in production, employment, real income, and other indicators. A recession begins when the economy reaches a peak of activity and ends when the economy reaches its trough.”
What Happens in a Recession?
During a recession, the economy falters. Declines can be seen across many key areas.
- Employment. The unemployment rate typically increases during a recession as companies lay off workers to reduce their costs.
- Consumer demand. Retail sales decrease during a recession as consumers have less disposable income. This in turn impacts businesses, forcing them to reduce costs.
- Economic output. As the cost of raw materials rises during a recession, businesses may scale back production, causing a slowdown in manufacturing.
Individuals living through a recession may see their wages flatten or fall as employers try to cut expenses. The cost of living can also increase as a result of inflation. With fewer jobs available during a recession it could be harder to find employment.
What Causes Recessions?
Recessions have many potential causes. The most recent recession was caused by a Black Swan event, the COVID-19 pandemic. Prior to that, the Great Recession of 2007-2009 was caused by problems in the financial markets. A combination of low interest rates, easy credit, light regulation, and toxic subprime mortgages caused the housing market to crash.
Recessions can also be triggered by major price changes in the inputs needed to produce goods and services. We saw this in 1973, with the Organization of the Petroleum Exporting Countries (OPEC) oil embargo, a decision to stop exporting oil to the United States. Oil prices soared, rising as much as 300%. The oil embargo is widely viewed as the cause of the 1973-1975 US recession.
Central banks raising interest rates in an effort to contain inflation can contribute to tipping an economy into recession. This is the situation we are currently in. Higher interest rates can have a negative impact on business. People with debts have less money to spend because they are paying more interest to their creditors. This leads to a decline in retail sales. In addition, companies with debts have less money for the operation of their business, because they must now pay more in interest.
Psychology can also contribute to a recession. A lack of consumer confidence and a sense of fear can lead to a downward spiral, as people cut back on spending and companies slash operating costs to manage an expected fall in demand.
Are we in a Recession?
In the United States, GDP declined for two consecutive quarters; Q1 and Q2 of 2022.
Six months of contraction is the most popular definition of a recession, often cited in the media.
However, while economic growth is negative, the US job market remains strong. In July, the unemployment rate sank to 3.5%, matching its lowest level in the last 50 years.
Speaking at a press conference in late July, Federal Reserve Chairman Jerome Powell stated: “I do not think the US is currently in a recession and the reason is there are too many areas of the economy that are performing too well.” He added, “This is a very strong labor market … it doesn’t make sense that the economy would be in a recession with this kind of thing happening.”
While the US economy has not yet been declared to be in a recession by NBER, warning signals are mounting and some analysts forecast that an economic downturn will begin later this year or in 2023.
Recession Predictors and Indicators
Early warning signs of recession include the following:
- A decline in manufacturing orders
- Weakness in the stock market and housing market
- High interest rates
- Low consumer confidence and spending
- Reduced real (inflation adjusted) income
- Rising unemployment
- Rises in bankruptcies, defaults, or foreclosures
- An inverted yield curve
An inversion in the yield curve is considered to be an important predictor of a recession, although sometimes they have inverted without a subsequent recession. A yield curve is a line plotting the interest yield of bonds with equal credit quality but different maturity dates.
A normal or upward-sloped yield curve indicates that yields on longer-term bonds may continue to rise. This is generally viewed as healthy and consistent with an environment of positive economic growth. By contrast, an inverted yield curve is one where longer-term bonds have a lower yield than short-term bonds. This reflects expectations for lower long-term interest rates and the possible onset of recession.
Is a Recession Coming?
NBER, the agency charged with identifying when recessions start and finish, has not yet signaled that the United States is in recession and analysts are divided on whether a recession is imminent.
Treasury Secretary Janet Yellen recently said that an American recession “is a risk when the Fed is tightening monetary policy to address inflation.” Inflation remains high despite the substantial rate hikes from the Federal Reserve. Consumer confidence rebounded more than expected in August after three consecutive monthly declines. Meanwhile, the unemployment rate ticked higher from historic lows in August. The economic data is mixed, but the threat of a recession remains on the horizon.
Meanwhile, the picture is clearer in the UK. The British Chambers of Commerce (BCC) has stated that it expects the UK economy to enter into recession before the end of the year, with a forecast of negative economic growth for Q2, Q3, and Q4.
How to Prepare for a Recession?
Recessions are an inevitable part of the economic cycle. Here are some ways you can prepare yourself for when one arrives.
- Have one or ideally multiple steady income streams
- Work on building up an emergency fund
- Try to avoid unnecessary expenses
- If you have money in stocks and a short-term investing horizon (less than three years) consider moving assets into bonds or cash
- Do your best to eliminate high-interest credit card debt
- Keep your resume and LinkedIn profile updated and ready, in case you need to start a new job search
When Was the Last Recession? (US and UK)
The last recessions in both the US and the UK took place during the COVID-19 pandemic.
According to NBER, the last US recession took place from February 2020 to April 2020. The recession was one of the shortest on record. The swift recovery was aided by the Federal Reserve implementing a broad range of policies to keep credit flowing and stem the negative economic impact of the pandemic.
The last UK recession was during Q1 and Q2 of 2020, lasting six months. This was also a relatively short recession but UK GDP did not return to pre-pandemic levels until late 2021.
Prior to the COVID-19 recession there was the Great Recession of 2007 to 2009 which resulted largely from the subprime mortgage crisis in the US. It was the longest recession for both the US and the UK since the Second World War.
How Long do Recessions Last?
Data from the IMF tells us that recessions usually last about a year and a country’s GDP typically falls by about 2% to 5%. The study showed that between 1960 and 2007, 21 advanced economies were in recession for about 10% of the time.
Recessions may last as little as a few months, but the economic recovery to the former peak can take years. Recessions are considered an unavoidable part of the business cycle.
The following models are used to describe recovery from recession.
- V-shaped recovery: A rapid economic decline followed by an equally fast rebound to pre-recession levels. This represents the ideal recovery scenario.
- U-shaped recovery: In this instance there is a slower recovery after the decline. The economy remains around the trough for a period, then gradually ascends.
- W-shaped recovery: Also called a “double-dip” recession, in this case we see an economy fall into recession and recover. It then immediately moves into another recession and recovery.
- L-shaped recovery: Here we see a steep economic decline followed by very slow recovery, This is the worst possible scenario.