What is a recession, and how does it affect the economy?

Is the US economy in a recession? Are we headed for one? These questions are asked anytime the economy hits a rough patch, but what distinguishes an official recession from a slowdown? Read along as we discuss what recessions are, what causes them, and how the government and the Federal Reserve (Fed) work to minimize their effects.

What is a recession?

Recession has been defined as two consecutive quarters of falling gross domestic product (GDP). But economists tend to believe this oversimplifies matters. A recession is a significant decline in economic activity that is spread across the economy and lasts for an extended period. It may include drops in GDP, income, employment, manufacturing, and retail sales.

Many measures may point to a recession, but one organization — The National Bureau of Economic Research (NBER) — makes the final call on what qualifies. The NBER is a nonprofit and nonpartisan network of more than 1,800 academic economists.¹ Its Business Cycle Dating Committee combs through reams of data to track the highs and lows of economic activity. It defines a recession as the “period between a peak of economic activity and its subsequent trough.”²

What causes a recession?

Recessions can have many causes. And previous recessions have generally been triggered by some combination of factors ranging from declining consumer confidence to a long period of high interest rates to external shocks. Here’s a look at some of the potential contributors:

1. Decline in consumer confidence

When consumers lose faith in the economy, they tend to cut back on spending. Because consumer spending accounts for approximately 70% of the US economy, a drop in demand for goods and services can reduce business revenues and lead to layoffs.³

2. High interest rates

Elevated interest rates may also push down consumer and business spending as the cost of borrowing increases. Rates that are high for too long can contribute to recession.

3. Financial instability

Financial instability, brought on by excessive debt or a banking crisis, can create a credit crunch. Consumers and businesses can’t get loans, which chokes off spending and investment and slows down economic activity.

4. External shocks

Geopolitical conflicts, natural disasters, pandemics, and other major events can affect supply chains and increase costs. Shocks that curtail production and consumer spending can create severe disruptions that spread through the economy.

5. High inflation

Rapidly rising prices often make it more difficult for consumers to afford goods and services. This erosion of purchasing power may reduce spending and slow down economic growth.

6. Global economic conditions

Economic downturns in major trading partners can reduce demand for US exports, impacting domestic economic health. This reduction in export demand can lead to lower production and higher unemployment rates.

How are recessions predicted?

Certain indicators tend to make headlines when they're triggered.

For example, economists and financial analysts pay close attention to the yield curve, a leading indicator which shows the relationship between interest rates on short-term and long-term government bonds. An inverted yield curve, where short-term rates exceed long-term rates, has preceded many past recessions.

Also, the Sahm Rule has gained popularity as a recession indicator in recent years. Named after economist Claudia Sahm, the rule suggests that recession is likely when the three-month average unemployment rate rises by at least 0.5 percentage points above its previous 12-month low.

But while some indicators may get a lot of attention, economists and financial experts monitor a variety of data points to gauge the health of the US economy. Invesco’s Portfolio Playbook provides a monthly update of our macro regime framework and the leading economic indicators that we track.

How frequent are recessions?

Recessions happen with some regularity, but the timing, length, and severity can vary widely. Over the past 50 years, the US has experienced seven recessions.

• November 1973 – March 1975
• January 1980 – July 1980
• July 1981 – November 1982
• July 1990 – March 1991
• March 2001 – November 2001
• December 2007 – June 2009
• February 2020 – April 2020

What’s the difference between recession and depression?

Recessions and depressions are both periods of economic decline. But they differ significantly in length, severity, and impact. A recession tends to be short, typically lasting from a few months to a year. A depression is a much longer and more severe economic downturn with enduring effects on the economy. The Great Depression of the 1930s, for example, lasted about a decade and led to widespread unemployment, severe deflation, and a big fall in economic activity.

How can policymakers fight recessions?

The federal government has different fiscal policy tools to help stabilize the economy and promote recovery. More spending on infrastructure projects and social programs may stimulate economic activity and create jobs. Tax cuts or direct financial assistance to individuals and businesses may boost consumer spending and investment. With both approaches, the goal is to inject money into the economy and boost consumer confidence.

Monetary policy, as managed by the Federal Reserve, can also be used to spur economic activity. The Fed may drop interest rates to make borrowing cheaper so consumers and businesses can spend and invest. It may also resort to quantitative easing — buying government securities and other assets to boost money supply and drop long-term interest rates. Adding liquidity to the financial system makes it easier for banks to lend and businesses to invest.

Because recessions are marked by inflection points (where an economy’s growth changes direction), they’re most accurately identified in hindsight. But policymakers generally can’t wait for the official call before implementing measures to stimulate the economy. Lowering interest rates, for example, may help ease a downturn and promote recovery, but it takes a while for the impact of lower rates to be felt throughout the economy.

How can recessions affect investors?

Past recessions have led to more market volatility and declining stock prices, generally speaking. But the depth of the decline and the time to recovery have varied quite a bit depending on the severity of the recession.

Recessions aren't ideal, but their market impact has been mixed. The S&P 500 Index was positive during three of the past seven recessions listed above. In six of those recessions, the market was up at least 8% a year after the recession. And in five of them, the market was up at least 18% after two years.⁴

Despite challenges, recessions can open up opportunities for long-term investors. Falling asset prices sometimes make high-quality stocks available at discounted prices, helping a portfolio surge ahead when the economy rebounds. A well-balanced and diversified portfolio — one that spreads investments across asset classes and sectors — may reduce risk and help protect against market volatility. With a disciplined investment strategy, an investor can survive a recession and possibly thrive as the economy pulls out of it.