It’s very likely that you’ve already experienced the effects of a recession firsthand. After all, the whole world experienced a huge financial downturn from February to April 2020, thanks to the massive lockdowns and economic inactivity caused by the COVID-19 pandemic.
Now, as inflation continues to soar and the Federal Reserve struggles to tame it, there’s been heavy speculation that a new recession may be forthcoming.
If all of this talk is making you nervous — don’t fret.
In this piece, we’ll go over everything you need to know about recessions, including whether we’re actually headed toward one, and how to prepare yourself financially to weather the storm.
What is a recession?
The National Bureau of Economic Research — the entity responsible for declaring whether we’re in a recession or not — offers the following definition of a recession:
“a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”
Although most recessions are short, one of the key factors signaling that one may be underway is when the GDP experiences a sharp decline for two consecutive quarters.
The term “GDP” stands for gross domestic product, which is a measure that tracks the growth or decline of the market value of the goods and services produced by a country during a specific timeframe.
But what causes the GDP to fall?
Well… a combination of things, including:
- High inflation.
- High interest rates.
- Shifts in demand for goods and services.
High inflation forces people to cut their spending, as everything costs more. Likewise, rising interest rates make borrowing more expensive, so many consumers, as well as businesses and government agencies, refrain from taking out loans or applying for credit.
Tightened budgets cause the demand for certain products and services to fall (at least temporarily), so companies start cutting employees’ hours or laying them off to stay afloat, which also slows down production. This, in turn, causes investors to shy away from investing in certain sectors.
The combined lack of spending, borrowing, trading, and investing shrinks the economy and causes the GDP to fall.
Are we headed toward a new recession?
Back in April, Deutsche Bank was the first major financial institution to say that a recession may be coming our way. In its report, “Prepare for a hard landing,” the banking giant predicts the U.S. will be entering a recession in 2023, citing high inflation and rising interest rates as the key drivers.
Leon C. LaBrecque, executive vice president and head of Planning Strategy at Sequoia Financial Group, considers himself a “student of recessions.” He agrees with Deutsche Bank’s prediction.
“We are gaining warning signs, like the 10-2 inversion. This time it’s demand induced versus supply induced, but it is there nonetheless. The Fed is in a predicament that the real interest rate is still vastly too low and has now turned hawkish with more rate increases,” LaBrecque says.
“With the pandemic perhaps exacerbating the supply chain disruptions, and the fact that low unemployment is somewhat inflationary (to hire, you need higher wages), I could see a recession by early 2023,” he adds.
6 ways to protect yourself against a recession
Although there’s nothing you can do to stop a recession from knocking on your door, there are a few things you can do to protect your finances in case one comes our collective way.
Review your budget
LaBrecque says a key part of coming up with a good financial strategy to weather any recession is asking yourself the following: “What’s your cash flow? Good, bad, or ugly? What if your income goes down 20% or 40%?”
Recessions are often marked by high unemployment rates. According to the International Labour Organization, it is estimated that 114 million jobs were lost worldwide as a result of the COVID-19 recession, even though it only lasted about two months.
Now is a good time to assess whether you can afford your fixed expenses — such as your rent, utilities, groceries, and minimum debt payments — in the event that your income is substantially reduced.
If you have a habit of maxing out your budget each month, identify opportunities to cut back any unnecessary spending.
This includes: getting rid of subscriptions you don’t need or rarely use, switching to a cheaper cellphone plan, and evaluating your insurance coverage if you haven’t made any changes to your policy in years. That way, you’ll have some wiggle room in your budget if things go south.