Understanding recessions — and how to prepare for them.
If you pay even the slightest attention to the news, you’re aware of the concerns about a potential recession. And while you may have a general sense of the repercussions of a recession – i.e., you know it’s not good news – you may not know what exactly a recession is, or what you could do to prepare for one. If so, you aren’t alone; a recent survey found that almost two-thirds of Americans aren’t able to accurately describe a recession.
This article is here to help. We’ll explain what a recession is, how it might impact you, and what you can do to prepare for one. Let’s get started with a simple question:
What is a recession?
This isn’t as simple of a question as it sounds, since there are a lot of different ways to define a recession. Generally speaking, it refers to a period of time — which could be measured in months or years — when economic activity declines. In the 1970s, an economist named Julius Shiskin defined a recession as being marked by two consecutive quarters of declining gross domestic product (GDP). The National Bureau of Economic Research (NBER) — the authority in the U.S. on declaring whether we’ve had a recession — takes a more nuanced view that balances the depth, diffusion and duration of economic declines.
As you can see, recessions can be a bit tricky to identify. In fact, they can be so tricky that the NBER won’t declare the beginning and end dates of a recession until after the recession is already over. It’s possible the NBER will eventually declare that a recession is happening right now. After all, the U.S. economy began 2022 with two consecutive quarters of negative GDP growth. According to Shiskin’s definition, we technically are in a recession now. However, the NBER may not agree, since those two quarters of decline were followed by a quarter of 2.6% growth.
What causes a recession?
Recessions can be caused by any number of factors. Usually there’s some sort of shock to the system that results in economic uncertainty. The COVID-19 pandemic caused one of the most rapid and dramatic economic downturns in history. Within the span of about 30 days, the U.S. went from a position of relative economic strength with financial markets hitting record highs, to a global recession.
Excessive inflation is another likely culprit, which is one of the reasons why we’re currently hearing so much about a potential recession. Beginning in 2021, global inflation levels began to rapidly rise, and had spiked to the highest level in 40 years by June 2022. Central banks like the Federal Reserve responded by aggressively raising interest rates to tame inflation while trying to avoid any steps that could possibly hinder economic growth. These actions, along with the war in Ukraine and lingering effects of the pandemic, have added to the current uncertainty in the economic landscape.
What happens during a recession?
While a discussion of the definition and causes of recessions can feel academic, the impact they create can be very real. During most recessions, unemployment goes up and the total number of jobs can either stagnate or go down. People are more likely to lose their jobs, and if they do, it’s often harder to get a new one. Manufacturers often cut back on production in response to lower demand, so those who are employed may see their incomes stagnate or sometimes go down if their employers cut back on their hours.
If there’s any good news to be had when it comes to recessions, it’s that they’re always temporary. The 18-month recession of 2007–09 during the Great Financial Crisis, for example, was the longest one since the Great Depression, and of the 17 recessions that NBER has declared in the last 100 years, the average length was a little over 12 months. The most recent, 2020’s pandemic recession, lasted just two months.
Is the U.S. headed for a recession?
We discussed the topic with Scott Colbert, Commerce Trust’s chief economist.
Fed Chairman Jerome Powell has clearly stated the U.S. central bank’s focus is to fight inflation even at the expense of economic growth. The Fed has made progress in lowering inflation levels since it began aggressively hiking interest rates in early 2022. But as the saying goes, you can’t ignore history. Previous attempts to meaningfully lower inflation usually coincide with a rise in the unemployment rate, which typically is a precursor to a recession.
We believe the U.S. economy is likely to fall into a recession at some point in 2023. However, the severity and duration of the downturn remains to be seen.
How can I be prepared for a recession?
From a broad perspective, the best way to insulate your household from the impact of a recession is to improve your personal finances as much as possible. One of the best things you can do is to save money each month, and don’t touch it unless you absolutely have to. Even if you can only save a little, it’s worth it. It’s a good habit to get into, and over time, even small amounts add up.
How much should you save? A good rule of thumb is to set enough aside in a savings account to cover your basic expenses for up to six months. If you don’t know how much money that should be, then start by establishing a budget that details your income and expenses each month. From there, you can create a version of your budget that eliminates as much discretionary spending as possible — things you can live without if need be — to help determine how much money you need to get through a period of potential unemployment.
You could even start trying to cut costs now to give you more cushion in your monthly budget, thereby increasing your ability to add to your rainy-day fund. For example, you might eliminate a streaming service you rarely watch, eat at restaurants less often or cut back on buying new clothes for a while.
Another way to guard against the downsides of a recession is to have a “side hustle.” This could be anything from driving for a ride-share service to working weekends at a neighborhood coffee shop. Learn new skills that might help you earn additional income. Anything that helps you diversify your income is a good thing and makes you that much more financially resilient.
We have no control over whether we’re going to have a recession. But by understanding what causes recessions and the impacts they can have, you will hopefully be better able to navigate them. And while we may not know we were in a recession until it was over, it’s never a bad idea to be ready for one, just in case.