You’ve likely seen competing headlines about whether the economy is heading toward a recession.
Amid bank failures, high inflation, and a tumultuous stock market, experts and investors alike are concerned about the economy taking a nosedive. Cutting through the noise to understand how your personal finances will be affected can be challenging. For the economy to be in a recession, economists have to see a significant decline over a long period of time in GDP, employment rates, production, and other factors.
What is a recession?
A recession is a period of sustained, significant decline in economic activity. A common metric experts use to determine if the economy is in a recession is if there are two consecutive quarters of declining gross domestic product (GDP). However, there are a lot of factors that go into determining a recession, including unemployment rates, retail sales, and manufacturing activity. Declines in economic growth are a regular part of the economy’s cycle, yet some recessions, like the financial crisis in 2008, were notably worse and more destructive.
Why do recessions happen?
Recessions are caused by a number of economic factors and are influenced by current events and economic policy. This can monetary policy, which is implemented by the Federal Reserve, and government regulation or deregulation. Recessions are part of the business cycle, which is the pattern of economic expansion and contraction that economies regularly go through.
Here are the key factors that cause recessions:
- Large scale geopolitical events and natural disasters can trigger a recession. For example, the Covid-19 pandemic caused a lag in economic activity when nations implemented lock downs. Natural disasters can break infrastructure, disrupt supply chains, can cause unemployment or unavailable workers, and lead to economic anxiety and uncertainty.
- Financial imbalances, like high levels of debt on a large scale or asset bubbles, can also trigger a recession. When these bubbles burst, they lead to huge losses for both individuals and businesses and contribute to economic slowdowns.
- Both out of control inflation and excessive deflation can contribute to a recession because they can affect people’s consumer spending habits and wages. The Federal Reserve combats inflation by raising interest rates, which can also contribute to economic slowdown.
How do experts know when the economy is heading toward a downturn?
For the economy to be considered in a recession, there must be multiple measurements of various economic activities that are declining or weak. Widespread unemployment, falling retail sales, negative GDP growth, and declining manufacturing are all signs that the economy is taking a nosedive. Declining GDP is the most common metric, but not the only one that experts use to determine if we are in a recession. For example, in 2022, there were two consecutive quarters of declining GDP, but many experts argued we were not in a recession because the labor market was strong.
The National Bureau of Economic Research (NBER) is the body that officially recognizes whether the economy is in a recession or not. The NBER says we are in a recession when there is a significant decline in economic activity across the economy lasting more than a few months, evident in real GDP, real income, employment, industrial production, and retail sales.
Recession vs. depression
While both recessions and depressions are lags in economic activity, depressions are far more severe. While there is no standard definition of a depression, it is understood to be a more drastic recession that goes on for a longer period of time.
View this interactive chart on Fortune.com
3 ways to protect your personal finances during a recession
During a recession, it is crucial that you make sure you have an emergency fund.
Part of the reason that it is important to have cash on-hand is that it’s crucial that you aren’t forced to sell your stocks during a downturn. While it might feel tempting to get out of the market when the economy is tanking, trying to time the market is a losing game for most investors. “Investors who panic when markets drop due to tougher economic times end up selling low and then rebuying much higher later when psychologically they feel better again,” explains Bill Bolen, financial advisor at Homrich Berg, a wealth management firm. “Liquidity is your friend when times are tough and you want to keep that safety reserve in case you personally get a bad surprise,” he adds.
The most effective portfolio during any downturn is one that spreads out your assets and is built for the long term. If you follow a budget that works for you and don’t make huge purchases that you can’t keep up with, you will be set up well to endure through economic downturns. “Preparation means not taking your eye off the ball and sticking to your plan even when times seem really good with no danger on the horizon, because once you see the recession coming it is typically going to be too late to recover and make adjustments,” Bolen says.
To build long-term wealth, it’s important to design an investing portfolio that prioritizes long-term growth while mitigating risk. Options like a Roth IRA can be great for long-term goals like saving for retirement. As we’ve seen with past recessions, investors who stay the course set themselves up for long term gains when the market eventually recovers.
How long do recessions last?
The length of a recession depends on the specific circumstances of the economic downturn. In general, recessions tend to be shorter than expansions, which are periods of economic growth. According to the NBER, the average length of a recession since World War II has been about 11 months. Monetary policy, fiscal policy, government spending, or technological innovations can all affect the recovery from a recession. For example, the Federal Reserve has been raising interest rates in past months with the intention of easing inflation. Often recessions are fixed by a combination of public sector and private sector participation. For example, during the emergence of the Covid-19 pandemic, the U.S. government sent stimulus checks to individuals to help ease the impact of the recession on individuals and families and trigger economic activity.
The takeaway
A recession is a sustained period of declining economic activity, often measured by GDP, unemployment, and manufacturing. While recessions are concerning, it’s important to remember that the best course of action as an investor is staying the course and not selling your assets out of fear. As in past economic downturns, the market will recover and you will be set up for long term gains down the road.
