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Recession

A slowdown in general economic activity

What is a Recession?

Recession is a term used to signify a slowdown in general economic activity. In macroeconomics, recessions are officially recognized after two consecutive quarters of negative GDP growth rates. In the US, they are declared by a committee of experts at the National Bureau of Economic Research (NBER).

 

Recession

 

Recessions are considered a part of the natural business/economic cycle of expansion and contraction. An economy starts to expand at its trough (weakest point) and similarly starts to recede after reaching its peak (highest point). A deep recession that lasts for a long time eventually translates into a depression. In the early 1900s, the Great Depression lasted several years and witnessed a GDP decline in excess of 10%, with unemployment rates peaking at 25%.

 

Indicators of a Recession

 

1. Gross Domestic Product (GDP)

Real GDP indicates the total value generated by an economy (through goods and services produced) in a given time frame, adjusted for inflation. Negative real GDP indicates a sharp drop in productivity.

 

2. Real income

Real income is calculated by measuring personal income, adjusting it for inflation, and discounting social security measures such as welfare payments. A decline in real income reduces purchasing power.

 

3. Manufacturing

The health of the manufacturing sector, taking into account overall exports/imports and trade deficits (or a trade surplus) with other countries, signifies the strength and self-sufficiency of an economy.

 

4. Wholesale/Retail

Both wholesale and retail sales, adjusted for inflation, are also measured to gauge the market performance of goods.

 

5. Employment

A high rate of unemployment is a lagging indicator. It typically confirms an economy’s pivot into recession stage rather than predicting a recession in the future. Usually, unemployment rates nearing 6% of the total workforce are considered problematic.

 

Causes of a Recession

 

1. Real factors

A sudden change in external economic conditions and structural shifts can trigger a recession. This fact is explained by the Real Business Cycle Theory, which says a recession is how a rational participant in the market responds to unanticipated or negative shocks. For example, a sudden rise in oil prices due to growing geopolitical tensions can harm crude oil-importing economies. A revolutionary technology that causes automation in factories can disproportionately impact economies with a huge pool of unskilled labor.

 

2. Financial/Nominal factors

According to a school of economics called monetarism, a recession is a direct consequence of over-expansion of credit during periods of expansion. It gets exacerbated by insufficient money supply and credit availability during the initial stages of a slowdown. There is a significant correlation between monetary and real factors, such as interest rates and relationships between certain goods. The relationship is not explicit because monetary policy instruments such as interest rates also encompass institutional responses to anticipated slowdowns.

Financial indicators of an upcoming recession are often tied to benchmark interest rates. For example, the Treasury yield curve inverted in the 18 months preceding the last seven financial crises in the US. In addition, a sustained fall in equity values shows lower expectations for the future.

 

3. Psychological factors

Psychological factors include excessive euphoria and overexposure of risky capital during an economic expansion period. The 2008 Global Financial Crisis was, at least in part, a result of irresponsible speculation that led to the formation of a bubble in the housing market in the US. Psychological factors can also manifest as curtailed investment that is a result of widespread market pessimism, which lacks grounds in the real economy.

 

Effects of a Recession

Recessions cause standard monetary and fiscal effects – credit availability tightens, and short-term interest rates tend to fall. As businesses seek to cut costs, unemployment rates increase. That, in turn, reduces consumption rates, which causes inflation rates to go down. Lower prices reduce corporate profits, which triggers more job cuts and creates a vicious cycle of economic slowdown.

National governments often intervene to bail out key businesses that face potential failure or structurally important financial institutions such as large banks. Some companies with foresight and planning understand the implicit opportunity created by the lower cost of capital as interest rates and prices fall, and are actually able to take advantage of a recessionary period. A larger pool of unemployed workers enables employers to recruit more qualified candidates.

 

More Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

  • Cyclical Unemployment
  • Economic Indicators
  • Inflation
  • Federal Reserve

Financial Analyst Certification

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