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What is a recession?

Here are the signs a recession is coming and how it impacts you.

Yahoo Personal Financeยท Getty Images
Ben Luthi
7 min read

A recession is an economic downturn that can have a significant negative impact on an economy and the corporations and individuals within it.

Recessions are normal in the life cycle of an economy and can be a result of several different causes. That said, understanding how they work and their potential impacts can make it easier for you to prepare for one.

A recession is a sustained period of negative economic growth that can last for several months or even years. Recessions are a natural part of an economy's life cycle, which is made up of four periods:

  • Expansion: Following an economic downturn, financial markets, consumer spending, and job growth start to pick up again.

  • Maturity: As economic expansion begins to mature, wages, the job market, and consumer and business spending are strengthened. Additionally, business profit margins and financial markets see significant gains while inflation maintains a comfortable rate.

  • Aging: At this point, job growth, industrial production, and spending start to slow, resulting in declining profits, volatile financial markets, and accelerating inflation.

  • Recession: During this period, unemployment grows and consumer spending falls, resulting in declining profits for businesses and shrinking economic growth.

Many economists and governments consider an economy in recession if it's experienced two consecutive quarters of negative growth โ€” usually measured by the country's gross domestic product (GDP).

However, some experts argue that it's important to look at additional factors, such as income data, consumer and business spending, industrial production, and the labor market.

Read more: How to protect your savings against inflation

Prior to the Great Depression, which began in 1929, the terms recession and depression could have been used interchangeably. Since then, economists have used the term recession to describe milder economic downturns to avoid inciting the consumer panic that exacerbated the Great Depression.

While depressions can still occur, the term is generally only used for severe recessions lasting several years.

Economies are incredibly complex, so there's no single factor economists can point to when it comes to a recession. In general, experts point to several different causes, including the following:

If a specific industry grows at an unsustainable rate, its asset values may become overinflated as investors rush to get a piece of the pie. This is known as an asset bubble. However, if new money becomes unavailable or the industry can't maintain its rate of expansion, it could result in the bubble bursting, causing a ripple effect throughout the economy.

Two relatively recent examples of asset bubbles include the dot-com era in the late 1990s and the housing market of 2007 and 2008.

If an economy grows too quickly, businesses bump up against the maximum supply of available resources and human capital. Stiff competition can increase demand, resulting in higher prices and reduced profit margins.

At that point, unemployment may increase as businesses scramble to cut costs through layoffs, and financial markets may suffer as investors cut and run.

As unemployment grows, consumer spending decreases, resulting in more losses for businesses and reduced economic output on a larger scale.

As economies around the world have globalized, they're increasingly dependent on each other for predictability and stability.

Wars, pandemics, and economic collapses in other countries can all create uncertainty for both businesses and individuals, resulting in economic contraction.

Read more: How to recession-proof your savings

The U.S. has experienced dozens of recessions in its history, according to the National Bureau of Economic Research, with an average length of 17 months.

The Great Depression is the longest economic recession in modern history, lasting from 1929 to 1941. Since 1945, however, the average length of a recession has been just over 10 months. The most recent recession was caused by the coronavirus pandemic but was short-lived due to a variety of government stimulus programs.

Here's a quick look at the recessions that have occurred since the Great Depression:

While identifying recessions isn't an exact science, economists pay attention to several indicators to predict when they might happen. Here are just a few of them:

  • GDP contraction: GDP is a measure of a country's total economic output, which is why many economists consider two consecutive quarters of negative GDP growth as the definition of a recession.

  • Growing unemployment: A rise in the unemployment rate indicates that businesses are laying off more employees and potentially reducing other spending. With less income, it's likely that decreased consumer spending will follow.

  • Inverted yield curve: In the bond market, yields typically follow an upward curve, with long-term bonds offering higher interest rates than short-term bonds. If the economy starts contracting, near-term risks increase, and investors demand higher interest rates on short-term bonds to compensate for that risk.

  • Declining industrial production: As an economy's expansion ages, companies may reduce their production to minimize their risks. This results in declining business spending, hiring, and profit margins, which can also lead to layoffs.

  • Investor sentiment: The Volatility Index is used to gauge financial market sentiment, particularly in terms of expected volatility in the S&P 500, a major benchmark of the U.S. stock market. The higher the index goes, the greater the risk of declining stock prices, which could indicate economic instability.

It's important to note, however, that none of these indicators is a clear sign on its own. For example, an inverted bond yield curve has historically been a pretty good sign of an impending recession. However, the U.S. economy has experienced one since early 2022 but has yet to enter recession territory.

Read more: I bond vs. high-yield savings account: Which is better for beating inflation?

A recession can have wide-ranging effects on businesses and individuals alike, but the exact impact can vary depending on your situation and the exact causes of the economic downturn.

With that in mind, here are some general ways a recession can impact you:

  • Job instability: As businesses look to cut costs, your job may be at risk. If you get laid off, it can be more difficult to find new employment due to hiring freezes.

  • Financial struggles: If your income goes down or you lose your job, you may be unable to make ends meet without relying on debt. Thatโ€™s one reason why itโ€™s important to have a well-funded emergency savings account.

  • Reduced access to credit: To minimize their exposure to risk, financial institutions may raise their interest rates for borrowing and tighten their credit requirements, making it harder to get approved for affordable financing options.

  • Investment losses: As an economy contracts, you can expect the stock market to take a significant hit, resulting in investment losses for your portfolio. If you don't need the money anytime soon, it may not have a lasting effect on you. However, if you're nearing retirement or need your investment funds for other short-term financial objectives, it could have a drastic impact on your financial well-being.

Read more: High-yield savings account vs. investing: Which is right for you?

Each recession is unique, with some lasting a couple of months and others several years. Since 1945, the average length of a recession in the U.S. is 10.3 months.

The most recently recorded recession in the U.S. occurred in 2020 as a result of the coronavirus pandemic. The recession lasted just two months.

Due to increased unemployment, the demand for consumer goods and services typically drops during a recession, resulting in some prices decreasing. However, things don't get cheaper across the board.

For example, prices for essential goods and services, such as groceries and utilities, typically don't budge much. In contrast, non-essential items and services, such as travel and entertainment, are more likely to become less expensive.

If you're on a fixed income, you may be able to take advantage of lower prices that result from economic contraction. A recession can also be a good time for investors who can afford to take advantage of lower stock prices.