What is a recession? Why the most horrifying term in economics isn’t what you always think
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It’s the most frightening term in economics, but it’s also the most misunderstood: Recession.
Forget everything you think you know about the term at a time when fears about the first contraction since the short-lived coronavirus pandemic swirl both Wall Street and Main Street. Nearly 7 in 10 Americans (or 69 percent) said in a Bankrate survey from August they were worried about the possibility of a recession before the end of this year. Layoff announcements, meanwhile, are dominating headlines, from Goldman Sachs and Coinbase to Amazon and Microsoft.
Not helping the panic is many Americans’ most recent experiences with recessions. The only two that an entire generation has lived through over the past 20-plus years were devastating events.
But don’t get swept up in the noise. Experts say few recessions are like the Great Recession and coronavirus pandemic-induced dip, and today’s economic situation is far different.
All of that means, understanding recessions is more crucial now than ever, so you can prepare your personal finances wisely for any economic event, downturn or not.
What is a recession — and what isn’t?
You might have heard that a recession is when the financial system contracts for two consecutive quarters, as reflected in gross domestic product (GDP) — the broadest scorecard of the U.S. economy. Experts, however, say that oversimplifies it.
“That’s the rule of thumb that’s often been used,” says Eric Swanson, economics professor at the University of California, Irvine, who spent 10 years at the Fed. “But the last couple of recessions, it’s not quite been true.”
Technically speaking, a recession is when the National Bureau of Economic Research’s Business Cycle Dating Committee says so. That bloc of eight research economists has the sole authority of declaring when recessions start and end. Their official definition claims that a significant decline in economic activity across the financial system for longer than a few months marks a downturn.
- Real personal income excluding transfer payments;
- Two Department of Labor measures of employment (a household and business survey, conducted monthly);
- Consumer spending adjusted for inflation;
- Wholesale-retail sales adjusted for inflation; and
- Industrial production.
“There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions,” according to the committee.
Officials have their reasoning. The simplest is that data is regularly adjusted and revised. GDP, for instance, is published three total times over a two-month period before it’s finalized. By then, data could tell a completely different story.
Economists also stress that you can’t infer a trend just from a single data point. In December 2020, for example, the U.S. economy lost 115,000 jobs while the broader economy chugged along from the pandemic-induced recession. Meanwhile, the U.S. economy actually contracted in the first quarter of 2014, yet it wasn’t even halfway through the longest expansion on record at the time.
The committee has also declared a recession without seeing two subsequent quarters of decline. Case in point: The dot-com boom and bust, when the economy only shrank for one quarter.
“Most of the recessions identified by our procedures do consist of two or more consecutive quarters of declining real GDP, but not all of them,” according to the committee.
When are recessions declared?
Americans likely won’t know the U.S. economy is in a recession until it’s well underway, and they’re also unlikely to know right when a downturn officially ends.
For instance, officials didn’t officially declare the Great Recession had begun until December 2008 — a year into the downturn. Americans and economists had even longer to wait for the coronavirus pandemic’s official end date: 15 months after the fact.
Economists do have popular recession signals. A popular one, known as the “Sahm rule,” suggests the economy is in a recession when the unemployment rate rises by 0.5 percentage points from its previous 12-month low.
Part of the reason why recessions are tricky to spot is because data is released with a lag.
Yet, the committee’s definition of a recession implies two important points about spotting a downturn: A wide variety of data has to generally follow the same direction (down), and that movement has to persist for a longer stretch of time. When multiple data points start to edge down, that’s when Americans can infer that a contraction might be afoot.
Even with recession fears far and wide, data has yet to clearly indicate a downturn has begun. The financial system shrank for two straight quarters starting in March 2022, yet employers added jobs at a pace faster than before the pandemic and joblessness is at a half-century low. Americans’ livelihoods and incomes often depend on the job market, which has been “the least dirty shirt in the laundry list of economic data series we monitor,” says Mark Hamrick, Bankrate senior economic analyst.
That’s something the committee is unlikely to ignore. Payrolls are one of “two measures we have put the most weight on” in recent decades, along with real personal income, the group said.
Still, the job market’s strength isn’t felt in every industry. Layoffs are perking up across the tech and financial services sectors, with data from Challenge, Gray and Christmas shows job cuts are up 13 percent from the prior year.
What causes a recession?
If knowing when the U.S. economy is in a recession is a difficult task, predicting what causes a recession is even harder — if not impossible.
No one foresaw a global pandemic wrecking the longest U.S. expansion on record. Instead, most economists wondered whether it might be the trade war between the U.S. and China or the Fed tightening rates too much that officially tipped the financial system over.
Recessions have differing variations, degrees and depths, and each of them is caused by something different; however, they generally happen when there’s some sort of external shock — either on the demand or supply side.
In the early 1980s, the Fed clamped down on boiling inflation and inflation expectations by intentionally causing a recession. In 2001 and 2008, busts in the stock and housing market were to blame.
“If you talk to professional economists, there’s no tendency for booms to die of old age,” says Swanson, who is a research associate at the NBER. “There’s always going to be something someday that disrupts the economy.”
The same generally goes for predicting how severe a downturn may be. Not all recessions have the same flavor; some come with greater impacts than others. Joblessness surged to 10 percent in the aftermath of the Great Recession, with almost 8.7 million jobs lost between December 2007 and February 2010. That was the most severe recession since the Great Depression — until it was eclipsed by the coronavirus pandemic more than a decade later, which put nearly 1 in 4 out of work and cratered nearly 22 million jobs.
“When thinking about recessions, the catalyst determines the severity, the length and the subsequent recovery,” says Ryan Sweet, chief economist at Oxford Economics. “When you have a financial crisis, a recession is pretty significant and long, and the recovery is slow. You have to repair household balance sheets; you have to repair corporate balance sheets. The next recession, if we do have one, it’s going to be very mild. It shouldn’t be that long either because there’s no glaring imbalance in the economy.”
Why are recession risks high right now?
Experts in Bankrate’s Economic-Indicator survey say the U.S. economy has a 64 percent chance of entering a recession this year — making the next downturn, if it indeed happens, one of the most widely predicted recessions in recent memory, Hamrick says.
The future is impossible to predict, but today’s major recession risks all have to do with high inflation — or rather, what has to happen because of it. Fed officials are raising interest rates at the fastest pace in four decades to cool inflation.
Those fears are reminiscent of past experiences. The last time the Fed faced an inflation threat as severe as the one today, officials had to engineer a recession to slow demand and deflate price pressures. Joblessness soared to almost 11 percent as a result, according to data from the Department of Labor.
Fed officials are unlikely to take interest rates to a level as high as they did back then (the U.S. central bank’s benchmark rate hit a peak range of 19-20 percent), but they could still bring interest rates to 5-5.25 percent, if not higher, according to the Fed’s economic projections. Borrowing costs haven’t been at 5 percent or higher since 2006.
And similar to challenges for members of the Business Cycle Dating Committee, Fed officials are making judgments based on backward-looking data. The risk is, they could end up raising rates too much and not realize it until it’s too late.
“It’s not our intended outcome at all, but it’s certainly a possibility,” said Fed Chair Jerome Powell at a June 21 testimony, referring to a recession. “We do think that it’s absolutely essential that we restore price stability, really for the benefit of the labor market as much as anything else.”
What a recession means for your money
Generally, recessions mean periods of elevated joblessness, reduced spending and pessimistic outlooks. Any hit to employment can make it harder to afford both the items you want and need — but so can high inflation, underscoring why Americans might be feeling as if they’re living through a downturn already, even despite half-century low unemployment.
One can understand why a strong job market has been regarded as irrelevant for those who are employed but struggling to pay for the things they need or want. For many Americans, the experience of high inflation has been significant as it has reduced their buying power.
— Mark Hamrick, senior economic analyst
Think about building an emergency fund and plan ahead to how you’d respond to a spell of unemployment. That might mean applying for unemployment insurance (UI) and staying in touch with your networks, who can let you know about job opportunities. It’s also important to evaluate your purchases in the months ahead and prepare for harsh economic times while the financial system looks like it’s still on stable footing.
“A recession will occur at some point,” Sweet says. “It doesn’t have to be next month or next year, but at some point, we will experience it.”