SoFi

A recession is a period of general economic contraction. Recessions are typically accompanied by falling stock markets, a rise in unemployment, a drop in income and consumer spending, and increased business failures.

Recessions tend to have a wide-ranging economic impact, affecting businesses, jobs, everyday individuals, and investment returns. But defining what, exactly, a recession is, and the long-term repercussions they may have on personal financial situations is tricky.

Different Recession Definitions

A recession is often defined as a drop in gross domestic product (GDP) — which represents the total value of goods and services produced in the country — for at least two quarters in a row. However, this is not an official definition of a recession, and instead, is just a shorthand that some economists and investors use when analyzing the economy.

Recessions are officially defined and declared by the Business Cycle Dating Committee at the National Bureau of Economic Research (NBER). So, when GDP dropped two straight quarters in 2022 (Q1 and Q2), the NBER didn’t declare a recession because other indicators, such as unemployment, didn’t necessarily align with a recessionary environment.

Consumers and workers may believe that the economy is in a recession when unemployment or inflation rises, even though economic output may still be growing. That can affect all sorts of things, including the stock market, and put a damper on investors’ hopes as they trade stocks and other securities.

Recommended: Recession Survival Guide and Help Center

NBER’s Definition

The NBER defines a recession as a significant and widespread decline in economic activity that lasts a few months. The economists at the NBER use a wide range of economic indicators to determine the peaks and troughs of economic activity. The NBER chooses to define a recession in terms of monthly indicators, including:

•   Employment. Job growth or job loss can be used to gauge the likelihood of a recession, and serve as a litmus test of sorts for which way the economy is moving.

•   Personal income. Personal income can play a direct role in influencing recessionary environments. When consumers have more personal income to spend, that can fuel a growing economy. But when personal income declines or purchasing power declines because of rising interest rates, that can be a recession indicator.

•   Industrial production. Industrial production is a measure of manufacturing activity. If manufacturing begins to slow down, that could suggest slumping demand in the economy and, in turn, a shrinking economy.

These indicators are then viewed against the backdrop of quarterly gross domestic product growth to determine if a recession is in progress. Therefore, the NBER doesn’t follow the commonly accepted rule of two consecutive quarters of negative GDP growth, as that alone isn’t considered a reliable indicator of recessionary movements in the economy.

Additionally, the NBER is a backward-looking organization, declaring a recession after one has already begun and announcing the trough of economic activity after it has already bottomed.

Julius Shiskin Definition

The shorthand of using two negative quarters of GDP growth can be traced back to a definition of a recession that first originated in the 1970s with Julius Shiskin, once commissioner of the Bureau of Labor Statistics. Shiskin defined recession as meaning:

•   Two consecutive quarters of negative gross national product (GNP) growth

•   1.5% decline in real GNP

•   15% decline in non-farm payroll employment

•   Unemployment reaching at least 6%

•   Six months or more of job losses in more than 75% of industries

•   Six months or more of decline in industrial production

It’s important to note that Shiskin’s recession definition used GNP, whereas modern definitions of recession use GDP instead. GNP, or gross national product, measures the value of goods and services produced by a country both domestically and internationally. Gross domestic product only measures the value of goods and services produced within the country itself.

How Often Do Recessions Occur?

Economic recessions are a normal part of the business cycle. According to the NBER, the U.S. experienced 33 recessions prior to the coronavirus pandemic. The first documented recession occurred in 1857, and the most recent was caused by the Covid-19 pandemic, which started in February 2020 and ended in April 2020.

Since World War II, a recession has occurred, on average, every six years, though the actual timing can and has varied.

How Long Do Recessions Last?

According to the NBER, the shortest recession occurred following the onset of the Covid-19 pandemic and lasted two months, while the longest went from 1873 to 1879, lasting 65 months. The Great Recession lasted 18 months between December 2007 and June 2009 and was the longest recession since World War II.

If you consider the other 12 recessions following World War II, they have lasted, on average, about ten months.
Periods of economic expansion tend to last longer than periods of recession. From 1945 to 2020, the average expansion lasted 64 months, while the average recession lasted ten months.

Between the 1850s and World War II, economic expansions lasted an average of 26 months, while recessions lasted an average of 21 months.

The Great Recession between 2007 and 2009 was the most severe economic drawdown since the Great Depression of the 1930s. This recession was considered particularly damaging due to its duration, unemployment levels that peaked at around 10%, and the widespread impact on the housing market.

6 Common Causes of Recessions

The causes of recessions can vary greatly. Generally speaking, recessions happen when something causes a loss of confidence among businesses and consumers.

The mechanics behind a typical recession work like this: consumers lose confidence and stop spending, driving down demand for goods and services. As a result, the economy shifts from growth to contraction. This can, in turn, lead to job losses, a slowdown in borrowing, and a continued decline in consumer spending.

Here are some common characteristics of recessions:

1. High Interest Rates

High interest rates make borrowing money more expensive, limiting the amount of money available to spend and invest. In the past, the Federal Reserve has raised interest rates to protect the value of the dollar or prevent the economy from overheating, which has, at times, resulted in a recession.

For example, the 1970s saw a period of stagnant growth and inflation that came to be known as “stagflation.” To fight it, the Fed raised interest rates throughout the decade, which created the recessions between 1980 and 1982.

2. Falling Housing Prices

If housing demand falls, so does the value of people’s homes. Homeowners may no longer be able to tap their house’s equity. As a result, homeowners may have less money in their pockets to spend, reducing consumption in the economy.

3. Stock Market Crash

A stock market crash occurs when a stock market index drops severely. If it falls by at least 20%, it enters what is known as a “bear market.” Stock market crashes can result in a recession since individual investors’ net worth declines, causing them to reduce spending because of a negative wealth effect. It can also cut into confidence among businesses, causing them to spend and hire less.

As stock prices drop, businesses may also face less access to capital and may produce less. They may have to lay off workers, whose ability to spend is curtailed. As this pattern continues, the economy may contract into recession.

4. Reduction in Real Wages

Real wages describe how much income an individual makes when adjusted for inflation. In other words, it represents how far consumer income can go in terms of the goods and services it can purchase.

When real wages shrink, a recession can begin. Consumers can lose confidence when they realize their income isn’t keeping up with inflation, leading to less spending and economic slowdown.

5. Bursting Bubbles

Asset bubbles are to blame for some of the most significant recessions in U.S. history, including the stock market bubble in the 1920s, the tech bubble in the 1990s, and the housing bubble in the 2000s.

An asset bubble occurs when the price of an asset, such as stock, bonds, commodities, and real estate, quickly rises without actual value in the asset to justify the rise.

As prices rise, new investors jump in, hoping to take advantage of the rapidly growing market. Yet, when the bubble bursts — for example, if demand runs out — the market can collapse, eventually leading to recession.

6. Deflation

Deflation is a widespread drop in prices, which an oversupply of goods and services can cause. This oversupply can result in consumers and businesses saving money rather than spending it. This is because consumers and businesses would rather wait to purchase goods and services that may be lower in price in the future. As demand falls and people spend less, a recession can follow due to the contraction in consumption and economic activity.

How Do Recessions Affect You?

Businesses may have fewer customers when the economy begins to slow down because consumers have less real income to spend. So they institute layoffs as a cost-cutting measure, which means unemployment rates rise.

As more people lose their jobs, they have less to spend on discretionary items, which means fewer sales and lower revenue for businesses. Individuals who can keep their jobs may choose to save their money rather than spend it, leading to less revenue for businesses.

Investors may see the value of their portfolios shrink if a recession triggers stock market volatility. Homeowners may also see a decline in their home’s equity if home values drop because of a recession.

When consumer spending declines, corporate earnings start to shrink. If a business doesn’t have enough resources to weather the storm, it may have to file for bankruptcy.

Recommended: How to Invest During a Recession

Governments and central banks will often do what they can to head off recession through monetary or fiscal stimulus to boost employment and spending.

Central banks, like the Federal Reserve, can provide monetary policy stimulus. The Fed can lower interest rates, which reduces the cost of borrowing. As more people borrow, there’s more money in circulation and more incentive to spend and invest.

Fiscal stimulus can come from tax breaks or incentives that increase outputs and incomes in the short term. Governments may put together stimulus packages to boost economic growth, as the U.S. government did in 2009 and in 2020.

For example, stock market volatility increased wildly amid fears of the coronavirus pandemic and its economic fallout. To ward off recession, the U.S. government put together trillions in Covid-19 stimulus packages that included direct payments to citizens, suspended student loan payments, a boost to unemployment benefits, and a lending program for businesses and state and local governments.

Recessions vs Depressions and Bear Markets

Though recessions, depressions, and bear markets may all feel or seem similar, there are some differences investors should be aware of.

Recessions vs Depressions

When a recession occurs, it could stir up uneasy feelings that perhaps the economy will enter a depression. However, there are significant differences between recessions and depression. While recessions are a normal part of the business cycle that last less than a year, depressions are a severe decline in economic output that can last for years. Consider that the Great Recession lasted 18 months, while the Great Depression lasted about ten years.

Recessions vs Bear Markets

A recession is also different from a bear market, even though many think the two events go hand-in-hand.

A bear market begins when the stock market drops 20% from its recent high. If you look at the benchmark S&P 500 index, there have been 14 bear markets since 1945.

Yet, not all bear markets result in recession. During 1987’s infamous Black Monday stock market crash, the S&P 500 lost 34%, and the resulting bear market lasted four months. However, the economy did not dissolve into recession.
That’s happened three other times since 1947. Bear markets have lasted 14 months on average since World War II, and the most significant decline since then was the bear market of 2007–2009.

That’s why it’s important to keep in mind that the stock market is not the same as the economy, though they are related. Investors react to changes in economic conditions because what’s happening in the economy can affect the companies in which investors own stock.

So, if investors think the economy is growing, they may be more willing to put money in the stock market. They will likely pull money out of the stock market if they believe it is contracting. These reactions can function as a sort of prediction of recession.

Recommended: Bear Market Investing Strategies

Is It Possible to Predict a Recession?

Economists and investors try to predict recession, but it’s difficult to do, and they often end up wrong. Economists usually frame the possibility of a recession as a probability. For example, they may say there’s a 35% chance of a recession in the next year.

There are several methods economists use to try to predict recessions. Some of the most common include analyzing economic indicators, such as employment and inflation, as well as consumer and business confidence surveys. Economists build models with these economic indicators as inputs, hoping the data will help them determine the path of economic growth. While these methods can indicate whether a recession might be on the horizon, they are far from perfect.

One issue in predicting a recession is that a lot of data analysts use to forecast the economy are backward looking indicators. These data, like the unemployment rate or GDP, present a picture of the economy as it was a month or more prior. Using this data to paint a picture of the present economy becomes difficult and adds to the complexity of predicting a recession.

However, many analysts believe the yield curve is the best indicator to help predict a recession. When the yield curve inverts, meaning that the interest rate on short-term Treasuries is higher than on long-term Treasuries, it is a warning sign that the economy is heading to a recession. An inverted yield curve has occurred before all 10 U.S. recessions since 1955. Notably, however, the yield curve inverted in 2022, and a recession did not subsequently occur (yet).

The Takeaway

Recessions are periods of economic contraction, and are usually accompanied by rising unemployment and a falling stock market – though that’s not always the case.

The possibility of a recession can be unsettling, causing you to think of economic hardships and spark fears of personal financial troubles. However, recessions are a regular part of the business cycle, so you should be prepared for one if and when it comes. When it comes to investing, this means building and maintaining a portfolio to meet long-term goals.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

SoFi Invest®