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What Is A Recession? Why The Most Horrifying Term In Economics Isn’t What You Always Think

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Written by Sarah Foster – 8 min read – Edited by Mary Wisniewski 

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. Stocks have slid, and the S&P 500 is in a bear market. In recent weeks, major CEOs from J.P. Morgan Chase’s Jamie Dimon to Tesla’s Elon Musk have warned about an “inevitable” downturn and a “hurricane” barreling toward the U.S. economy. Even rapper Cardi B has joined the chatter, remarking that we could already be living through a recession.

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.

Perhaps the scariest part of all: Congress and the Federal Reserve don’t look like they’re going to come to the rescue like they did during the coronavirus pandemic. And inflation is showing no signs of slowing yet on its own.

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. Not to mention, the Fed’s act of pumping stimulus out of the economy — even as sentiment sinks — is a key part of making sure things don’t go from bad to worse.

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.

Those officials don’t just look at GDP. They pay attention to:

  • 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 several months after the fact.

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.

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.”

Is the U.S. economy heading toward a recession?

You’ll want to keep the Business Cycle Dating Committee in mind as we move into the next few months of the year.

Recession fears were renewed when growth in the first three months of 2022 contracted by 1.5 percent. Risks of the U.S. economy flatlining — or worse, contracting — in the second quarter of this year are also growing, according to a closely watched GDP tracker from the Atlanta Fed.

“This is where we could really talk ourselves into a recession,” says Ryan Sweet, senior director of economic research at Moody’s Analytics.

Yet, experts point out continued strength in the labor market. Joblessness is at a near half-century low, businesses have had more than 11 million openings for five straight months and workers are still quitting at near-record rates, a sign of continued confidence. Even weekly applications for unemployment benefits are holding close to pre-pandemic levels.

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.

We have a lot of inflation right now — we all know that, we all see it, we all hate it and we all feel bad because of it. Feeling bad about the economy because of inflation is not the same thing as feeling like I’m going to lose my job. … Both are bad feelings, but they’re different. – Eric Swanson, Economics professor at the University of California, Irvine

But it’s not to say the U.S. economy is out of the woods. Fed officials in their June meeting signaled plans to raise interest rates to a target range of 3.25-3.5 percent by the end of 2022. If that happens, it would mark the most tightening in a single year since the 1980s and 1.5 percentage points higher than they initially thought rates would rise back in March. Investors are bracing for the Fed to raise rates even further than that: to 3.5-3.75 percent by the end of this year, according to CME Group’s FedWatch. Layoffs are perking up across the tech and financial services industry, from Coinbase to Redfin.

The Fed’s more aggressive outlook is all because inflation has been red-hot — and it hasn’t shown any signs of cooling. But high inflation isn’t so much the fear right now. Instead, it’s that the Fed might have to raise rates too much, too fast. And considering just how much economic indicators lag, the Fed might not know that it’s overdone 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 will the next recession be like?

It’s easy to get caught up in recession fears when Americans remember the past. 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. Nearly 4 million lost their homes to foreclosure, according to the Chicago Fed. 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.

The last time the Fed faced an inflation threat as severe as the one today in the 1980s, officials had to engineer a recession. Joblessness then soared to levels higher than in 2008.

Although it’s impossible to predict what the next recession will be like, experts at this point aren’t expecting a recession caused by the Fed’s over-tightening to be as severe as either of those downturns.

The disease might also be the medicine. Simply by acting tough, the Fed has already managed to talk rates up. The 10-year Treasury yield has soared 1.64 percentage points since December 2021, while the average rate on the 30-year fixed rate mortgage has risen nearly twice as fast as the Fed’s benchmark interest rate, according to Bankrate data. In the week that ended on June 22, the key home-financing loan rose to 5.91 percent, up from 3.18 a year ago.

The last time around, the Fed let inflation drift out of control for nearly two decades before officially flushing it out in the ‘80s — a reason why it had to clamp down so hard.

“The inflation problem is not nearly as bad yet as it was in the early 1980s,” Swanson says. “There’s still a good chance the Fed can do it without a recession, but if there is a recession, I would expect it to be not too bad — a mini version of 1981.”

What a recession means for your money

But we’re a long ways away from being on the other side of the inflation problem. And for consumers feeling the pinch, they might already feel like they’re living in a downturn already — even without an official declaration from the NBER’s committee.

How a recession feels for everyday people often comes down to what causes the downturn and how long it lasts. Recessions spurred by financial crises, for example, tend to be some of the hardest to recover from. Consumers and companies have bad loans or capital to get off their books before they can start making investments or spending again.

That’s different from a recession brought on by the Fed tightening too much. Theoretically, the Fed could start to reduce rates again once inflation shows signs of slowing. When would that happen, however, is the ultimate question.

“What the Fed could face soon is: Do they cause a recession now — be it a mild one — to bring down inflation, or do they risk sometime next year teetering or flirting with a recession and inflation is still high,” Moody’s Sweet says. “It’s a nightmare scenario for the central bank.”

Generally speaking, recessions mean periods of elevated joblessness, reduced spending and pessimistic outlooks. In other words, it’s 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. 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.

“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.”

Bankrate, posted on SouthFloridaReporter.com, June 27, 2022

Republished with permission

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