What is a Recession?

When the economy is doing well, it can be hard to imagine that anything could go wrong. But recessions are a natural part of the economic cycle. After a period of economic strength, the economy may decline and enter into a recession. 

But what is a recession, and what does it mean for you? A recession is a prolonged period of economic decline, and it can impact the job market, wages, and the cost of everyday goods and services. 

While that may sound alarming, understanding a recession’s impact can help you plan for the future and protect your finances. 

What is a recession? 

How to define a recession is a hotly debated topic among economists. But the most common definition — and the one used by the National Bureau of Economic Research (NBER) — defines a recession as a decline in economic activity that lasts for several months and affects a significant portion of the economy rather than just one or two sectors. The NBER is a nonprofit research agency that determines when recessions officially begin and end in the United States. 

Because the NBER may wait as long as 21 months to declare a recession, it’s possible to experience a recession’s effects before the NBER officially declares it a recession. 

What causes a recession? 

Recessions are complex, and there isn’t one single cause. Some factors that can lead to a recession include:

Overheated economy

The economy may become “overheated” when it grows too quickly. Usually caused by low interest rates and increased demand, businesses and manufacturers can’t keep up. We saw this recently in the last few years; builders couldn’t produce houses fast enough, so the prices on existing homes skyrocketed. But this effect can’t last. Eventually, people start spending less and the supply catches up with the demand.

Asset bubbles

Asset bubbles, defined by a surge in prices that far exceed the product or asset’s fundamental value, can lead to market volatility and rapid declines. For example, the “dot-com” stock bubble contributed to the 2001 recession, and the 2007–2009 recession was caused, in part, by the housing bubble. 

Economic shocks

Negative, unexpected events, such as the COVID-19 pandemic, can cause significant declines in the stock market and overall economy. 

Reduced lending

As inflation rises and the economy worsens, lenders may reduce lending and increase interest rates, making it more difficult for consumers and businesses to tap into loans or lines of credit. 

Increased business costs

When companies have higher production expenses, such as increased oil prices, overall production costs climb.

Decreased consumer spending

Because businesses have higher business and manufacturing costs, production can slow, so fewer products are available. As a result, the cost of common household goods and services increases. The higher prices make some items unaffordable, and consumers cut back their spending. 

5 signs of a recession

How do you know you’re in a recession? There are five key signs: 

Unemployment rates rise

When there is a recession, companies look to slash their costs, so layoffs and wage freezes are common. 

Consumers spend less

During a recession, consumers become more cautious with their budgets and spend less money.

Industrial production declines

The combination of higher production costs and lower consumer spending can cause companies to scale back production. This effect is reflected in the country’s gross domestic product (GDP) reports, which measures the value of goods and services produced in the U.S.  

Stock prices drop

As consumer sentiment declines, stock prices tend to decrease, too.

Housing prices decline

During a recession, consumers are less willing to spend money and banks tighten lending requirements, so the demand for housing declines. As a result, home prices tend to decrease, and houses may be on the market longer. 

What happens in a recession?

Although the term “recession” refers to a widespread economic trend, you may experience the effects of a recession in your day-to-day life. 

Notably, you might see steep price increases on everyday items, including groceries, gasoline and clothing. Rising prices can make it difficult to stay within your budget when household essentials like eggs or cleaning supplies become more expensive. 

Layoffs can be common, so you may have less job security than before. And even if you keep your job, you can expect your salary to stagnate. During recessions, companies often implement pay freezes and reduce cost-of-living raises or annual bonuses.  

If you do lose your job, it can take longer to find a new one. With more job seekers on the market, competition increases, so it can take several months before you secure a new position. 

How long do recessions last?

Recessions are a natural part of the economic cycle. In fact, there have been five recessions since 1980.

Historically, recessions are relatively brief. According to the Federal Reserve Bank of San Francisco, the average recession lasts for about 10 months. Periods of expansion — where the economy is strong — typically last for 57 months, so we tend to have more good times than bad. 

Recession vs. depression

Both “recession” and “depression” are terms used to describe economic declines. However, a depression is far more severe than a recession. During a depression, unemployment can reach into double digits, and there are substantial declines in GDP. Unlike recessions, which typically last for a few months, depressions can last for years. 

The last depression the U.S. economy experienced was the Great Depression, which lasted from 1929 to 1939. During that time, over 20% of the labor force was unemployed, and the GDP declined by 30%. While we’ve had major recessions since then, none have come close to the Great Depression’s severity. 

Inflation vs. recession

Inflation is another term that is commonly used during periods of economic decline or uncertainty. But it’s very different from a recession. Inflation is a measure of the overall increase in prices for goods and services. Some inflation is expected and even encouraged, but when inflation gets too high, everyday essentials become prohibitively expensive, and it can stall the economy. 

The nation’s central bank, the Federal Reserve, will try to curb inflation through moves like raising its benchmark interest rate. But those hikes can trigger recessions, so it’s a careful balancing act. 

How to prepare for a recession

Recessions are unavoidable; they’re a normal part of the economic cycle. When times are good, you can protect yourself by taking the following steps: 

Build an emergency fund

Having an emergency fund will protect you in case you lose your job or become ill. Experts recommend stashing three to six months’ worth of expenses in a savings account. If that amount is too intimidating, start with a smaller goal, such as $1,000. 

Pay down debt

If you can, pay down existing debt, such as high-interest credit cards or auto loans. Reducing your debt obligations will make it easier to make ends meet if prices increase. 

Cut expenses

Reviewing your budget and eliminating unnecessary expenses is a good way to free up cash for saving, investing or debt repayment. And reducing your expenses will make it easier to afford your bills during a recession. 

Build new skills

Even if you feel your job is secure, don’t get too complacent. Learning new skills and keeping your resume updated will make it easier to find a new job if you are laid off. 

How to survive a recession

Going through a recession can be stressful, especially if you haven’t been in the workforce during a recession before. But recessions are temporary, and here are some tips to help you get through it: 

Build multiple income streams

If you have several streams of personal income, the possibility of losing your job during a recession won’t be as scary. Picking up a side hustle or renting out a room in your home can help you bring in extra income that can cover the bills while you look for a new job or boost your emergency fund. 

Stick to a budget

During a recession, prices are higher, so creating a budget and tracking your spending will help you avoid overspending. 

Diversify your portfolio

Investing in a range of stocks and other securities, such as bonds, can help reduce the amount of risk you take on and help you weather a volatile market. 

What to invest in during a recession

During a recession, it can be tempting to halt investing because the market declines and your portfolio drops in value. But it’s important to stay the course and continue investing so you can take advantage of the market upsweep and compound interest. 

To reduce your exposure to risk, consider investing in exchange-traded funds (ETFs). They allow you to invest in hundreds or even thousands of stocks by purchasing one share, so you get exposure to many different companies at once. 

Investing regular, small amounts — regardless of how the market performs — can potentially reduce the average price you pay per share and decrease the impact of market changes. And with Acorns Invest, there are many ETFs you can invest in that match your investment goals and timeline, so you can maximize your returns over time.