In the news there is a lot of talk about inflation and the need to bring inflation back under control. High inflation means the economy is heating up, which means it's growing at what is deemed an unsustainable rate. And if an economy continues to grow at a such a rate it is likely that at some point it will blow up. Under control, according to the Federal Reserve (the Fed), is back to the 2% inflation target. In order to bring it down to that level the Fed is increasing interest rates to reduce spending power in the economy which should bring inflation back down.

However, this is not a fast process and there is a real danger that increasing interest rates could tip the economy into a recession.  But what is a recession, why do they occur and should we worry about it?

Gross Domestic Product

Gross Domestic Product or GDP for short, measures the monetary output of a country. That's to say, it measures the value of goods and services that are bought by a final user produced in a country in a given period of time. It can be thought of like the total financial output generated by a country over that period. If GDP grows then an economy is growing.  A growing economy is seen as a healthy economy and includes job creation, low unemployment, increases in new homes under construction and optimism in consumers, which means they go and and spend money. 

Recession

A recession is defined as a temporary economic decline during which trade and industrial activity are reduced. Technically this is generally identified as a fall in GDP (Gross Domestic Product) in two successive quarters. A decline in the economy typically means that economic output, employment and consumer spending all drop. That means unemployment rises, the feel good factor is gone and both consumers and businesses have less money to spend. During a recession businesses bankruptcies will increase so many companies will cut back on investment, expenses and the number of staff that they employ in order to survive. This means that companies often halt investments in infrastructure and staff which can further damage an economic recovery. Recessions are also bad for governments because they reduce the level of taxes received and they tend to reduce people's satisfaction with those in power.

Boom and Bust

Most economies grow steadily and though significant economic contractions are an exception, recessions are still relatively common.  According to the International Monetary Fund (IMF), there have been 122 recessions in advanced economies from 1960 to 2007. In fact, they state, recessions affect economies roughly 10% of the time. Economies tend to move between boom and bust. Boom when the economy is growing and bust when economic growth stalls or contracts. The last major recession was caused by the 2008 Global Financial Crisis. Luckily most recessions tend to be relatively short lived so the economy soon gets back on track. This is however, of course, no comfort for those how have lost jobs and businesses during the recessionary period.

Balancing Act

By increasing interest rates the ability for businesses and consumers to spend/invest is reduced. This adds as a break on the economy and it will cool down. The problem with all things economic though is that they take time and it's not always clear when the effect is being felt. There in lies the conundrum for the Fed or indeed any central bank: cool down at the correct rate and hit the 2% target or cool down too much, overshoot the target and force the economy into recession.

Double Dip

Worse still is a double-dip recession. This is a situation in which an economy experiences a short-lived recovery from a recession, followed by a second period of economic contraction, leading to a second downturn in economic activity. The term "double dip" refers to the shape of the recession when graphed over time, which resembles the letter "W". The first dip is the initial decline in economic activity, followed by a short-lived recovery or "dead cat bounce," and then a second, more prolonged decline in economic activity. So just when you think you're coming out of a recession you go back into one.

Summary

The boom and bust nature of economies means that recessions are inevitable (or maybe better put is that us humans haven't yet figured out how to manage stable long term growth). If you can see a recession coming then it makes sense to review spending and investments, whether you're a consumer or a business, to prioritise strictly necessary spend and eliminate all others. If you don't see one coming but one arrives then you should do that as soon as possible. The potential upcoming recession is certainly the best telegraphed recession in history; forewarned is forearmed as they say.

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