How is the economic contraction in the US explained?
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New York (CNN Business) --
The warning signs of a recession are flashing around the world.
Wall Street is restless.
Central banks are raising interest rates to try to contain inflation.
And geopolitical turmoil is exacerbating supply chain difficulties that began in 2020.
Deutsche Bank economists warned last month: "We will face a bigger recession," betting on a bearish stance alongside Wall Street.
Bank of America, taking a dispiriting but less dire stance, called sentiment in financial markets "recessionary."
Goldman Sachs is among the most optimistic, but not exactly cheerful: the struggling job market has "significantly increased the risk of a recession," it said recently.
Meanwhile, the Bank of England on Thursday warned of the possibility of double-digit inflation and a possible recession as it raised its key interest rate by a quarter of a percentage point.
China's economy, the world's second largest economy, is stalling and threatens to undermine global growth.
And Russia's war in the Ukraine is exploding food and energy prices in the European Union and the rest of the world.
Consumer price inflation reached a new high in 40 years in the United States
If we can go by history, the recent rise in inflation suggests that we are close to a contraction in the economy.
With one exception, every recession in the US economy has been preceded by a price spike, according to the Congressional Research Service.
So what exactly is a recession and how worried should you be?
Let's do a review.
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What is a recession?
First, the textbook definition: A recession is a prolonged period of economic decline, beginning when the economy peaks and ending when it bottoms out.
Recessions are often marked by the economy shrinking in consecutive quarters, typically measured by gross domestic product (that is, how much we collectively buy and produce as a society).
But there are exceptions to that rule, including the brief and extremely deep recession the United States entered during the early months of the pandemic.
And that technical designation doesn't mean much to anyone who isn't an economist (or a politician, someone just as or more interested in avoiding the "R" word than anyone on Wall Street).
How a recession affects you and your pocket
The reality of a recession is generally bleak from an economic standpoint: think rising unemployment, a declining stock market, and stagnant or falling wages.
People tend to curb spending when pessimism begins to permeate, giving recessions a psychological component that can be difficult to remove.
For example, the Great Recession that began in 2007 technically lasted only 18 months, but the impact of the crisis weighed on consumers for much longer.
Economists call this persistent effect, especially in the labor market, "hysteresis."
The 2020 recession was itself brief, but its massive layoffs and furloughs, coupled with a rapid shift to working from home, shattered previous assumptions about the value and meaning of work.
Around the world, workers' dissatisfaction with their employers has sparked a movement for something better, a phenomenon known as the "Great Resignation."
What causes a recession?
You could spend a career in economics researching and debating this very question.
But let's focus on the most pressing risk right now: the Federal Reserve's fight against inflation.
One of the quirks of the modern capitalist system we live in is that when the economy is going too strong, officials have to deliberately undermine it to keep it from going completely off the rails.
That is precisely what the Federal Reserve is trying to do now.
On Wednesday, the Fed raised its key interest rate by half a percentage point, the most aggressive increase in 22 years.
Interest rates are the Fed's main tool for controlling inflation, which is currently hovering around 8.5%, the highest level since the early 1980s.
Fed: New increase in interest rates seeks to control inflation 1:18
But predicting economic booms and busts is notoriously difficult, and the Fed has historically been bad at it.
Arriving late to the "economy is too hot" party, the Fed's job of taming it has become extremely delicate.
The bank has to raise interest rates enough to alleviate the extreme rise in prices.
If it is exceeded, demand could slump and cause a recession.
If you don't do enough, prices can continue to rise, which would also lead to a recession.
The ideal outcome is what is known as a "soft landing," in which consumer prices decline and economic growth continues at a steady pace.
How to prepare for the recession?
First of all,
don't panic:
even if a recession is inevitable, there's no telling how bad it will be.
But it never hurts to plan for the worst.
Financial advisors claim that you can insulate your finances from a recession.
Get a new job now:
With an ultra-low unemployment rate and plenty of job openings, it's a market for job seekers.
This could change quickly in the event of a recession.
Take Advantage of the Housing Boom:
If you're on the fence about selling your home, now may be the time.
US house prices are up nearly 20% year-on-year, but mortgage interest rates are rising too, which will eventually dampen demand.
Reserve some cash:
It is always a good idea to have liquid assets: cash, money market funds, etc., to cover urgent needs or unexpected emergencies.
(Here's a more complete list on how to prepare for a recession.)
Finally, a piece of wise advice for any market:
don't go with your emotions
.
"Stay committed and disciplined," says Certified Financial Counselor Mari Adam.
"History shows that what people, or even experts, think about the market is often wrong. The best way to reach your long-term goals is to keep investing and keep your allocation."
-- Matt Egan and Jeanne Sahadi contributed reporting.
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