What is a recession and how much should we fear?

Wall Street is on the edge. Central banks are raising interest rates to try to curb inflation. And geopolitical upheavals are exacerbating supply chain headaches that began in 2020.

“We will see a major recession,” Deutsche Bank economists warned last month, noting the bearish position on Wall Street. Bank of America, in a still dark but less scary camp, said the mood in the financial markets was “recessionary”. Goldman Sachs is among the big banks with more optimism, but it is not very cheerful: the tight labor market “significantly increased the risk of recession”, it was recently announced.
Meanwhile, the Bank of England warned on Thursday of double-digit inflation and a possible recession as it raised its key interest rate by a quarter of a percentage point. China’s economy, the world’s second-largest, is stalling, threatening to pull global growth. And the Russian war in Ukraine is raising energy and food prices through the roof in the EU and beyond.
If history is any indication, the recent rise in inflation suggests that a contraction awaits us. With one exception, every American recession since World War II was preceded by a general jump in prices, according to the Congressional Research Service.

So what exactly is a recession and how much do you need to worry about it? Let’s unpack it.

What is a recession?

First, the definition from the textbook: A recession is a long period of economic decline, which begins when the economy reaches a peak and ends when it reaches a bottom.

Recessions are usually marked by a contraction of the economy in consecutive quarters, usually measured by gross domestic product (aka, how much we buy and produce together as a society). But there are exceptions to that rule, including the brief and extremely steep recession the United States entered during the first months of the pandemic. And that technical label doesn’t mean much to anyone who isn’t an economist (or a politician – someone who is equally, if not more, interested in avoiding the word “R” than anyone on Wall Street).

The reality of the recession is generally economically bleak – think of rising unemployment, a falling stock market and stagnant or declining wages. People often curb consumption as darkness falls, giving the recession a psychological component that is difficult to shake off.

For example: Technically, the great recession that began in 2007 lasted only 18 months, but the impact of the crisis on consumers weighed much longer.

Economists call this long-term effect, especially in the labor market, “hysteresis.” The 2020 recession itself was short, but its mass layoffs and vacations, along with the rapid transition to work from home, shattered previous assumptions about the value and significance of the job. Around the world, workers ’dissatisfaction with their employers has spurred a movement in search of something better, a phenomenon known as the“ Great Resignation ”.

What causes a recession?

You could spend a career in economics researching and discussing this very issue. But let’s focus on the most pressing risk at the moment: the Federal Reserve’s fight against inflation.

One of the peculiarities of the modern capitalist system we live in is that when the economy becomes too strong, officials must intentionally hurt it to prevent it from completely derailing. This is exactly what the Federal Reserve is trying to do right now.

The Fed on Wednesday raised its key interest rate by half a percent, the most aggressive rate increase in 22 years. Interest rates are the Fed’s primary tool for controlling inflation, which is currently hovering at 8.5% – the highest since the early 1980s.

But predicting economic expansions and recessions is known to be difficult, and the Fed has historically been miserable at it. Late at the “economy is too hot” party, the Fed’s job of taming it has become extremely delicate. The bank needs to raise interest rates just enough to take the heat off rising prices. Exaggerate and demand could collapse, resulting in a recession. Do too little and prices could continue to rise, which would also lead to a recession.

The ideal outcome is known as a “soft landing,” in which consumer prices fall and economic growth continues steadily.

How should you prepare?

First, don’t panic: even if a recession is imminent, you can’t say how serious it will be. But it never hurts to plan the worst. Here are some ways financial advisors say you can isolate your finances from falling.

Lock up a new job now: with extremely low unemployment and a large number of jobs, it’s a job seeker market. That could change quickly in a recession.

Cash in on the housing boom: If you’ve been in doubt about selling your home, now might be the time to list. Real estate prices in the United States have risen nearly 20% year-over-year, but mortgage rates are also rising, which will eventually reduce demand.

Put some cash aside: it’s always a good idea to have liquid assets – cash, money market funds, etc. – to cover urgent needs or unexpected emergencies.

(Here’s a more extensive list of how to prepare for a recession.)

Lastly, some wise advice for any market: Don’t let emotions overwhelm you. “Stay invested, stay disciplined,” says certified financial planner Mari Adam. “History shows that what people – or even experts – think about the market is usually wrong. The best way to meet your long-term goals is to just stay invested and stick to your distribution.”

– CNN Business’ Matt Egan and Jeanne Sahadi contributed to this report.

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