What is a Recession? How Can We Tell if One is Coming?
The National Bureau of Economic Research (NBER) declares a recession when a nation’s economy experiences negative gross domestic product (GDP), rising levels of unemployment, falling retail sales, and contracting measures of income and manufacturing for an extended period of time. Recessions are often considered unavoidable parts of the business cycle.
What is a Recession?
A recession is a significant decline in economic activity that lasts more than a few months. This decline is significant enough to affect employment, manufacturing, retail sales, gross domestic product, and consumer income.
These metrics are measured and monitored by economists, and a recession is only declared by the National Bureau of Economic Research’s Business Cycle Dating Committee after a recession has ended. The NBER is the national source for measuring the stages of the business cycle.
How Long Do Recessions Last?
Most recessions are considered short, according to NBER data, with the average recession lasting 11 months from 1945 to 2009. Over the past 30 years, the US economy has gone through four recessions:
- The Covid-19 Recession – the most recent recession began in February 2020 and lasted only two months, making it the shortest recession in United States history.
- The Great Recession (December 2007 to June 2009) – The Great Recession was caused in part by a bubble in the real estate market. Despite remaining a recession, its long duration and severe effects earned it a similar name to the Great Depression. Lasting 18 months, the Great Recession was almost double the length of recent US recessions.
- The Dot Com Recession (March 2001 to November 2001) – At the turn of the century, the US was juggling a few major economic problems from the tech bubble crash to accounting scandals at companies like Enron, these troubles caused a brief recession.
- The Gulf War Recession (July 1990 to March 1991) – This recession was partly caused by spiking oil prices during the First Gulf War.
How Economists Predict Recessions
How can we know when a recession is coming? The NBER measures monthly statistics to give a timely estimate of economic growth or contraction. A recession is only confirmed by the NBER after the recession has ended, referencing real GDP numbers. The following are pre-emptive indicators or predictors of an impending recession as measured by the NBER.
The Yield Curve
An “inverted yield curve” is thought to be a signal of bad economic times ahead. Yield curve inversions have a solid track record of predicting recessions with advance notice, making it a leading indicator.
“Yield” here refers to the rate of return offered by a fixed income instrument, typically securities issued by the US Treasury. A yield curve is the shape formed by plotting the yields of those securities as a function of their time to maturity. Yield curves are based on a comparison of short-term and long-term interest rates.
Economic theory says that long-term borrowing carries more risk than short-term borrowing, so the interest rates for long-term bonds must be higher than the rates of short-term bonds. But actual market rates are set by market forces, and every now and then investors are willing to accept lower curves for long-term bonds than for short-term bonds. When that happens, economists say the yield curve is “inverted”.”
Declines in Consumer Confidence
Consumer spending is the leading driver of the US economy. If surveys show a sustained decline in consumer confidence, it could be an indication of impending trouble for the economy. If declining confidence is matched by lower spending, the economy will slow.
Real income, measured by the NBER, is an inflation-adjusted way to measure consumer purchasing power. Consumer confidence gives forecasters an idea of how comfortable consumers feel spending, while real income provides a more complete picture of how much consumers are actually earning that can be spent. When real income declines, so do consumer purchases and demand, which can be an indicator that a recession is coming.
One of the most common economic indicators for manufacturing is the ISM Manufacturing Index, which is calculated using data from a survey by the Institute for Supply Management (ISM). The goal is to measure monthly changes in demand by polling manufacturers regarding the demand they’ve faced in their factories.
Because the survey captures information on orders not yet started, it is often a good leading indicator for the direction of the economy. It is not a perfect indicator though because it often exaggerates both positive and negative signals and only looks at one piece of the overall economic picture.
Retail and wholesale sales, adjusted for inflation, tell economists how firms are responding to consumer demand. While manufacturing indicators seek to measure changes in economic activity by looking at producers, retail indicators look at buyers. Manufacturing happens based on forecasts and predictions, but consumer behavior in stores is what ultimately determines how much of a manufactured product gets sold.
A rising unemployment rate is likely a sign that a country’s economy is struggling, and prolonged above-average unemployment is a sure sign that the economy is not well. Unemployment is not very helpful in predicting recessions because job losses tend to happen mid-recession, not at the outset or in advance.
What Causes Recessions?
There are several possible causes of a recession, from sudden external factors such as a natural disaster to fallout from uncontrolled inflation.
Sudden Economic Shock
An economic shock is an unanticipated event that creates serious financial damage. The Covid-19 pandemic, which shut down economies worldwide, is one of the worst disruptions in the last century. In the 1970s, OPEC cut off the supply of oil to the US without warning, causing a recession. These shocks are ones that cannot be predicted.
Growing debt defaults and bankruptcies can capsize the economy if it grows to the point where no one can pay their bills. The housing bubble in the mid-2000s that led to the Great Recession is an example of debt causing a recession.
Asset bubbles are often caused by overconfidence in consumers. When the economy is strong, investors can become too optimistic. Former Fed Chair Alan Greenspan famously referred to this as “irrational exuberance.” Irrational exuberance inflates stock market or real estate bubbles. When a bubble pops, panic selling can crash the market, causing a recession.
Psychological factors can lead to a number of negative financial outcomes including a run on the bank.
Inflation is not a bad thing on its own, but excessive inflation can be dangerous. Central banks use monetary policy to control inflation by raising interest rates. Higher interest rates can depress economic activity. Excessive inflation was an ongoing problem in the US in the 1970s. To break the cycle, the Federal Reserve quickly raised interest rates, leading to a recession.
While out-of-control inflation can cause a recession, deflation can also contract the economy. Deflation is when prices decline over time, which causes wages to contract, which depresses prices further. When a deflationary feedback loop gets out of control, businesses and consumers stop spending, which undermines the economy.
Central banks and economists have few tools to fix the underlying problems that cause deflation. Neither fiscal policy nor monetary policy has answers.
Structural shifts include government policy changes, technological developments, or environmental changes. Sometimes these changes are positive but have caused a recession due to a delay in the economic learning curve.
New inventions, for example, increase productivity and help the economy over the long term but can be met with short-term periods of adjustment to technological breakthroughs. The Industrial Revolution made entire professions obsolete, leading to a short-lived recession. Today, some economists are concerned that AI and robots could have the same impact on certain industries.
Recession vs. Depression
A recession is a downward trend in the economy, marked by two or more consecutive quarters of economic contraction. Depression refers to a major downturn in the business cycle characterized by sharp and sustained declines in economic activity. Economic depressions are much more severe than recessions, and generally have a greater global reach while recessions remain relatively localized.
A recession can turn into a depression if it lasts long enough, but no set amount of time indicates a depression. The impacts of a recession are generally localized: lowering household income and spending and lower production and employment.
A depression, instead, is characterized by sharply reduced industrial production, high rates of unemployment, poverty, and homelessness, increased rates of bankruptcy, declines in stock markets, and reductions in international trade.
This material is provided for informational purposes only and should not be relied on as investment advice.