Economic Waves: Understanding Inflation and Recession
Similar to the ocean, the economy operates in waves, with two major factors being inflation and recession. Inflation leads to price increases for goods and services, while recessions signify economic slowdowns, often accompanied by rising unemployment.
Here's a breakdown of inflation versus recession and their interconnection, along with tips to prepare your finances for economic downturns from a financial advisor.
What is inflation vs. recession?
Inflation measures how much prices rise overall across many locations, whereas you may notice rising prices on specific items you frequently purchase in your area. It's typically expressed as a percentage reflecting the increase in prices over the past year.
People often associate inflation with negativity. But, a moderate level of inflation is actually beneficial. When demand for goods and services increases, companies may hire more workers and raise wages. This can have a positive impact on the economy by promoting growth.
If inflation goes above 2%, set by the Federal Reserve, it can harm your finances. When prices go up for things you need, you might have less money to save or spend on fun stuff. This can lead to people spending less and companies making less money. This tightening of belts can slow economic growth and potentially lead to increased unemployment, contributing to a recession.
A recession happens when the economy shrinks for a while. It can be caused by things like wars, pandemics, industry problems, or too much economic activity.
Identifying a recession isn't as simple as a single bad month or a news announcement. The National Bureau of Economic Research (NBER) determines official recession periods by analyzing economic data across multiple sectors over several consecutive months. Fortunately, recessions are often short-lived; for example, the COVID-19-induced recession of 2020 lasted only two months.
During a recession, companies reduce expenses by laying off employees. This can cause investors to withdraw from the stock market. As a result, stock prices may decrease. Despite this, history shows that the stock market tends to recover and grow over time.
While stock declines often coincide with recessions, they are not synonymous. A recession signifies overall economic contraction, whereas a bear market is a 20% or more decline in stock prices from recent highs. Although correlated, it's possible to have one without the other.
Does inflation cause recessions?
Inflation can lead to a recession under certain circumstances, including:
When inflation causes consumers to spend less, businesses may see lower revenues and the economy could experience negative growth.
Federal Reserve actions: If the Federal Reserve increases interest rates excessively to combat inflation, it can hinder businesses' ability to borrow money for growth. Additionally, higher interest rates may discourage people from taking out mortgages and auto loans, which can have a cooling effect on various industries.
Wage stagnation: Although wage growth typically outpaces inflation, if wages fail to keep up, consumers may reduce discretionary spending. This reduction in spending can negatively impact the economy.
Does inflation typically increase during a recession?
Not typically. In a recession, the economy slows, causing people to spend less and reducing the need for goods and services. As a result, prices usually drop, which slows down inflation.
However, there are exceptions. Inflation can rise during a recession, as seen in the 1970s when gas prices surged due to the Organization of Petroleum Exporting Countries (OPEC) cutting off shipments to the US during a war in the Middle East. When inflation occurs alongside economic stagnation, it's termed stagflation. Fortunately, stagflation is rare.
Managing inflation and recessions
Predicting high inflation or recessions is difficult, but these tips can help you prepare your finances for tough economic times.
Establish a plan
As emotional beings, our feelings, especially regarding money, can lead to unwise decisions. Having a financial plan with clear goals can prevent emotional decision-making and help you:
Stay invested during market downturns
Practice mindfulness in all financial decisions
Recession-proof your finances through various means
Whether your existing plan needs adjustment or you need to create one for the first time, a financial professional can provide valuable assistance.
Boost your emergency savings
Having a cash reserve can provide protection in various economic climates. When inflation increases, emergency savings can serve as a readily accessible fund to alleviate the impact of rising prices. Additionally, having a cash reserve can prevent you from resorting to high-interest debt on credit cards during periods of inflationary pressure. In times of recession, extra savings can help you navigate job loss and provide a buffer as you search for your next career opportunity.
Review your spending
During economic challenges, a budget can be invaluable. It provides a clear overview of your monthly income and expenses, helping you pinpoint areas where you can save. Trimming expenses doesn't necessarily mean eliminating all enjoyable activities; it's about finding opportunities to spend less in certain areas. However, it's important to continue saving for retirement and leave your emergency fund untouched, actions that can benefit you in the long term.
Evaluate your investments.
Inflation can erode your purchasing power, particularly during extended periods of high prices. It's essential to review your investment strategy in such situations. A well-diversified portfolio, where no single investment type dominates, can help cushion the impact of market volatility during periods of inflation or recession. Different investment types may respond differently to these economic conditions.
Additionally, consider assessing your portfolio to ensure it aligns with your retirement time horizon and risk tolerance. Typically, the longer you have until retirement, the more risk you can afford to take. Conversely, as retirement approaches, there's less time for investments to recover from losses, making a more conservative investment strategy more suitable.
Practice patience.
In times of uncertainty, it's easy to make impulsive decisions, such as buying high and selling low. Historically, recessions typically last less than a year. Inflation, on the other hand, can be more prolonged, as prices tend to rise more quickly than they fall. Regardless of the duration of inflation or a recession, having a financial plan, emergency savings, and a budget can help you navigate rough economic waters more smoothly.
Bottom Line
Understanding the dynamics of inflation and recession is crucial for navigating the complexities of the economy. While inflation leads to rising prices and recessions signify economic slowdowns, the relationship between the two is intricate. Despite the challenges they pose, there are strategies to prepare your finances for these economic downturns.
Sources:
https://www.fidelity.com/learning-center/smart-money/inflation-vs-recession
Disclosures:
This information is an overview and should not be considered as specific guidance or recommendations for any individual or business.
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