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What Is a Recession and What Causes It?

Stavros Tousios | Wednesday 28 December 2022

It has been months that economists have been forecasting that a recession is coming. There isn't as much agreement on how deep or how long recessions last, but there is a solid consensus that the economy is headed for a period of contraction in the early part of 2023. This opens up a couple of essential questions for traders such as what is a recession or what causes a recession?

What Is a Recession?

Recession Defined

There is no widely accepted, precise recession definition. But the most commonly accepted indicator of a recession is when we get two back-to-back quarters of negative growth in the Gross Domestic Product (GDP) That is understood as the total value of all the goods and services produced within the economy has diminished for six months straight.

In the case of the United States, however, the National Bureau of Economic Research (NBER) uses a broader recession definition. It includes employment and industrial production data, among others, to conclude whether a recession is happening as they track the start and finish dates for the said recession. NBER points out that the beginning of a recession can commence when economic activity advances to a peak point, and it can end with economic activity contracting to a low. In other words, they define a recession as a period of a downward trend.

What Happens During a Recession?

During a recession, economic output, employment, and consumer spending all decline. It's also likely that interest rates will decline as the central bank cuts the reference rate in order to support the economy. The government will see a widening deficit due to a loss of tax revenue while spending on social programs increases.

A recession brings about a major decline in economic activity that usually lasts for at least half a year and is accompanied by a decline in the stock market, an increase in unemployment, and a decrease in housing prices.

What Causes a Recession?

Many economic theories try to explain how and why an economy falls into recession. The causes can be broadly categorised into economic, financial, psychological, or a combination of all three.

Some focus on structural shifts in industries that have an important impact on the economy. Others point to financial factors, such as growth and accumulation of financial risks during the growth period preceding the recession. Those arguing that psychological aspects are the most crucial focus on the over-exuberance during economic booms, followed by pessimism when the downturn happens. An example of combining several factors could be the "Minsky Moment", named after the economist Hyman Minsky, which describes how an economic bubble grows and bursts based on financial and psychological factors encouraging unsustainable speculation.

How to Tell If a Recession Is Coming

There are early signs of an economic recession, such as high interest rates, an increasing number of bankruptcies, and weakness in the stock market, just to name a few. Among those is also the inverted yield curve, which is considered a vital signal of a potentially up-and-coming recession. Notably, the yield curve has inverted in the past without that leading to a recession. Usually, the yield curve is sloped upward, as longer-term debt has higher interest rates than shorter-term debt. Accordingly, an inversion occurs when short-term debt has higher interest rates than long-term debt. In turn, this reflects expectations for a possible onset of a recession.

Other indicators include declining manufacturing orders, weaker housing markets, and lower consumer confidence and spending.

Are We Headed for a Recession?

In fact, Fed Chair Jerome Powell does not think a recession is coming next year because the Fed has forecast that the economy will grow 0.5% despite expecting unemployment to increase by a percentage point. Surprisingly, many economists worry that the Fed will trigger a recession this time around after being able to rescue the economy from a recession in the prior two downturns. The Fed is taking the threat of inflation seriously and is expected to keep raising rates in the new year, which is one of the indicators of a possible recession. This is because a rapid increase in interest rates might slow growth or even incline the economy into a recession. Despite the Fed being confident it can thread the needle and just barely avoid falling into recession, its latest forecasts are in ranges typically associated with a recession. At the Fed’s last meeting on December 14, the Fed said it remains unwilling to "pivot" towards softer policy, as it intends to continue to fight inflation.  For now, whether or not the recession will continue making the headlines in 2023 is still unclear as the market is volatile, one will have to wait and see what the new year has in store. (Source:Reuters)

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