It seems like economists are as confused as the rest of us with the state of the economy. Some are predicting a recession. Some say we are in one. Others believe we are through the worst we’ll see nothing but expansion in the near future. What’s the truth? Who knows. But, let’s explore what is a recession, if we will have one, and what impact it may have on you.
What is a Recession?
The most common definition of a recession is two consecutive quarters of contracted growth. Contracted growth is usually measured as a reduction of Gross Domestic Product (GDP).
However economists disagree about whether or not we are in a recession largely because there are different ways of measuring recession. Employment rates, interest rates, business investment, and consumer spending are other ways to assess the health of the economy and those measures are sending mixed signals.
So, what’s happening with the GDP?
If we stick with defining a recession as two consecutive quarters of contracted growth, then we do not seem to currently be in a recession.
There was a downturn lasting one quarter from the fourth quarter of 2021 to the first quarter of 2022. And, there was an extremely short but dramatic recession in the first half of 2020 at the start of the pandemic. And, while the economy is not growing rapidly, recent data suggests that it is still growing.
Source: https://fred.stlouisfed.org/series/GDPC1#0
The National Bureau of Economic Research’s definition of a recession
The National Bureau of Economic Research (NBER) is recognized as the organization that defines the starting and ending dates of U.S. recessions. NBER maintains that there is no fixed rule for defining a recession, but that it involves “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”
What Triggers a Recession?
Causes of recessions can vary and are often complex. They can be triggered by various factors, including financial crises, bursts of speculative bubbles, sharp declines in consumer or business confidence, adverse changes in government policies, disruptions in international trade, or significant external shocks such as natural disasters or global pandemics.
How people feel about the future of the economy is an important predictor of a recession
A recession can become a self-fulfilling prophecy through a mechanism called a “confidence spiral.” It works as follows:
- When people perceive a recession is imminent, they start to reduce spending and become more cautious about their financial decisions.
- This reduction in spending and investment can lead to lower business revenues and profits, potentially resulting in layoffs and reduced consumer income.
- As a result, people’s expectations about the economy are confirmed, causing further reductions in spending and investment, thereby perpetuating the downward spiral.
Additionally, the behavior of market participants, including investors and businesses, can contribute to a self-fulfilling prophecy. If investors collectively decide to sell their assets due to expectations of a recession, it can lead to a market decline, further eroding confidence and causing economic conditions to deteriorate.
Confidence plays a crucial role in economic behavior, and when confidence is shaken, it can reinforce negative expectations and exacerbate a recessionary environment. Conversely, restoring confidence through effective policy measures and positive economic signals can help break the self-fulfilling cycle and support economic recovery.
Other indicators of a recession
An inverted yield curve: An inverted yield curve refers to a situation in which the interest rates on short-term bonds are higher than the interest rates on long-term bonds of the same credit quality. In other words, the yield curve, which typically slopes upward, becomes “inverted” and slopes downward.
Sudden stock market decline: A large decline in stock prices can be a sign of an oncoming recession since it signals pessimism about the future.
Rising unemployment: If employers experience less demand, they lay off employees. And high unemployment means that less people are spending money which further decreases demand.
You’ll Only Know a Recession Has Happened After the Fact
Recessions are typically defined after they have already occurred due to the nature of economic data and the need for sufficient evidence to determine the magnitude and duration of an economic contraction.
Recessions Are Happening Less Often
While we had a significant recession in 2008, economic downturns happen less often and for shorter periods of time due to fiscal and monetary policies like the federal regulation of interest rates and consumer safety nets like unemployment insurance that can soften the blow of unemployment.
You can see in the chart below how economic expansions have grown in duration over time.
Recessions Have Been Lasting for Shorter Periods of Time
The two most recent recessions, 2008 and 2020 were very different in duration. The Great Recession (2007-2009) lasted 18 months, which is quite long for an economic downturn. The recession that followed the beginning of the pandemic lasted only two months.
According to the NBER, the average length of a recession since 1854 is 17 months. However, more recent recessions (those since World War II) have lasted an average of 10 months.
How to Prepare for a Recession (or an Economic Expansion)
It actually doesn’t matter what direction the economy is headed. The following steps should be taken no matter what the future holds. These strategies will help safeguard your finances and mitigate the potential impacts of an economic downturn or financial shock while enabling healthy growth:
Maintain an emergency fund
Depending on your age, income sources, and overall asset allocation, you should have an emergency fund that can enable you to cover your living expenses for 3 months to 5 years.
Learn more about emergency savings and how much you should have.
Reduce debt
Paying down debt will free up more of your income and provide greater financial flexibility during an economic downturn. Additionally, avoid taking on new debt unless necessary and carefully consider the risks and affordability.
Diversify your income sources
Recessions can lead to job losses or income reductions. Therefore, consider diversifying your income sources to increase stability. Explore part-time work, freelance opportunities, or alternative income streams that align with your skills and interests. Passive income is also a great idea. Multiple income streams can provide a safety net during challenging economic times.
Understand your cash flow
It is important that you consistently evaluate your income and expenses so that you are aware of spending cuts than could be made if necessary.
Sufficiently diversify your assets
Assess your investment portfolio to ensure it aligns with your risk tolerance and long-term goals. Diversify your investments across different asset classes and consider a mix of low-risk and higher-risk assets. A well-diversified portfolio can help reduce the impact of market volatility during a recession.
Maintain adequate Insurance Coverage
Review your insurance coverage, including health insurance, life insurance, disability insurance, and property insurance. Ensure you have sufficient coverage to protect yourself and your assets. Insurance can provide financial support in the event of unexpected emergencies or losses.
Set and track toward long term financial goals
Recessions are temporary phases within the broader economic cycle. It is important to maintain a long-term perspective and avoid making hasty decisions based on short-term fluctuations. By staying focused on long-term goals, individuals can avoid making decisions that may have negative consequences in the future.
It is important to understand that the economy will thrive at times and struggle during other periods. But, historically over the long term, the economy has always expanded.
Maintaining a financial plan using a tool like the NewRetirement Planner can help you keep a long term perspective.
Don’t panic. Be rational.
Downturns are natural occurrences in the economy. Rational thinking helps individuals recognize that economic downturns eventually give way to periods of recovery and growth.
