During recession, you could lose your job. Getting loans from banks will not be that easy. Businesses will fail, stocks and NASDAQ might collapse. I am not trying to scare you!
Have you heard that Bank of England published a statement last week saying, they can’t rule out economic recession? They are expecting recession in UK around Christmas of 2022. Europe is already in recession because of disruptions in Ukraine or they are about to be in one. Technically recession is two quarters of negative GDP in a row. Last quarter we saw a 1.4% less decline in GDP for US. From 1900 onwards, an average recession lasts approximately 15 months. Every decade we have a recession and for first time since 1900s, last decade we didn’t had a recession. I think economic growth is going to fall sharply in second half of this year. I could be wrong. No one has the monopoly of the truth.
But I have to mention that everything I have written here is purely for educational and entertainment purposes. Nothing I have mentioned in my articles are financial advices. Do your own research.
What is recession?
Technically recession is two quarters of negative GDP in a row. Putting it in simple words, recession can be described as a mild decline in economic activity for a country in a month or it can be a long-lasting downturn that could last for years.
Supply and Demand
Considering the bigger picture, Recession is the effect of negative disruption between balances in supply and demand. That means a mismatch between the amount of goods people want, how much producers can offer and price that they are sold. Supply and demand quantities determine the prices of every product in the market. We should maintain that equilibrium. If supply rises or demand falls, prices drops. If supply falls or demand rises price increases. Clear?
How we slipped into higher inflation during Pandemic?
We are aware of the fact that government gave free money to all the citizens as stimulus checks during COVID pandemic. Since people have supplementary money, obviously they will spend more. Here, the equilibrium fall into pieces. There will be an increase in demand without equal growth in supply. The demand rises without increase in supply, means everyone have to pay more money for products and hence Inflation. Growing supply and demand together is the healthy way of economic growth.
Here is how Inflation leads to recession indirectly
The economy have a clear relationship with supply and demand. Inflation is not necessarily a bad thing. Low inflation rate is supposed to encourage economic activity. High inflation is when goods and services become more expensive and value of money decreases. So if inflation is matched with high demand and economic growth, it can’t be a bad thing in near future. Whereas a high inflation rate isn’t accompanied with high demand, it cause economic problems and hence recession.
- For example, in 2008, inflation rate recorded higher than nominal wages (which lead to a fall in real wages) and this contributed towards lower consumer spending and finally 2008 recession.
- It is possible inflation can indirectly cause a recession. If economic growth is too high, this can cause higher inflation and the growth can prove unsustainable and lead to a ‘boom and bust’ economic cycle. In other words, inflationary growth is often followed by a recession. Now you know where we are heading!
- Also, if inflation is way too high and if it starts to worsen the economy, the Central Bank or government may respond by tightening the monetary or fiscal policy. Yes. This reduces inflation but with a higher price to pay. It causes a fall in aggregate demand and lower economic growth. Therefore, a recession is often caused by policies to reduce inflation.
Tightening means increase of interest rates
Interest rates reflect the cost of taking on debt for individuals and companies. The rate is typically an annual percentage of loans that borrowers paying to debtors. During last few years the FED kept the interest rates nearly to zero. So Low interest rates means company can borrow more money and invest in their production and other investments. High interest rate means increase cost for both producers and consumers since they need more money to pay back the loan. It lead to slowing economic activity. Fluctuation in interest and inflation gives us the insight to the economy. This in how Inflation rates and interest rates affects the economy. But what causes these fluctuations? What causes the increase in inflation rates and what force feds to raise interest rates since they know it will severely affect the country’s economic growth?
Reasons and consequences
The reasons can be anything from geopolitical factors, natural disasters, wars or a flue that can kill millions! Everything that disrupts the balance of the supply and demand. Remember what we discussed earlier about supply and demand?
Consider a situation of earth quake in Russia, or a war in Ukraine that is happening now. It can disrupt the oil production in Russia or wheat production in Ukraine. Since Ukraine being one of the biggest supplier of wheat and Russia being the major supplier of oil in the world, their lack of production will affect the prices of these products. Supply side will charge more for wheat, oil or products that use oil. This discourages the demand (so both demand and supply goes down, which leads to economic slowdown) and the economy slip into recession.
What is happening around us now?
Corporates and institutions borrowed more money from central bank by thinking economic growth can help them handle the added burden. But when a pandemic like COVID or Russia-Ukraine war disrupts the harmony of the economy, it didn’t grow as quickly as expected. They may end up with more debts than they can manage. So they will be forced to redirect funds from business activity to pay debts, which reduces the growth.
To sum up
I am not predicting a recession in 2022 or 2023. The possibility of a recession can be eliminated if the government decide to come up with strict tightening. But if a recession comes, obviously this can be no happy factor for few months ahead. But it is inevitable for the long term economic growth. To understand that, you must understand the ‘long term business cycle’ or the Boom and Burst economic cycle.
There will be serious economic downturns in the near future but consider it as an opportunity to buy your favorite assets cheap. It can be housing markets, stocks, crypto or whatever you consider worth investing. Market is forward looking and so am I. We have to be cautious but we don’t have to worry about big bad cloud which howls around short term.
My intention was to make you aware of the basics of our economic cycle. I am aware of the importance of financial literacy and I want you to understand the same. Now we have discussed about what causes inflation and recession. In my next articles I will discuss about how recession will affect our daily life.
I will leave you a hint
In times of recession there are massive opportunities and fortunes to be made, so for new up and coming entrepreneurs, this is the time to go and start a business – Richard Branson