What is recession and how to identify it?

There is not a specific definition for recessions; however, according to the National Bureau of Economic Research’s (NBER) Business Cycle Dating Committee, an economy is said to be in a recession if there is a trough in the business cycle that is characterized by a negative Gross domestic product (GDP) and is accompanied by a general decline in the country’s economic activity and output such as high unemployment rates, contracting income, decreasing retail sales and declining industrial production for two consecutive quarters. Recessions are inevitable as they are part of the business cycle where economies undergo into different stages throughout time, starting with expansion, reaching a peak, then declining (recession) till reaching a bottom, and then recovering and the cycle goes on. Throughout history, a recession occurs almost every decade after a strong period of economic growth. A recession is sometimes considered healthy for the economy as it clears the road back to prosperity by ending an era of misallocation of investments.

Several factors determine whether a recession turns into a serious and protracted depression, including the volume and quality of credit provided during the preceding era of prosperity, the level of speculation authorized, fiscal and monetary policy potential to halt the downward trend, and the quantity of unutilized productive capacity. A depression in economics is a prolonged severe form of a recession that can persist for years. An example of depression is the 1929 Great Depression when GDP declined by 30%, industrial production fell by around 50%, and unemployment surpassed 20% during 1929-1933.

The bond market plays a role in identifying a recession. To be precise, the inversion of the yield curve is a key harbinger of recessions. It has accurately predicted the last 10 recessions; downturns are not brought on by the yield curve. Instead, it shows the course that investors believe the economy will take. If investors see an imminent slump in the economy, they will turn to buy long-term treasuries. Investors will hurry to purchase long-term bonds if they think a downturn is soon to come to lock their returns instead of risking to lose their money in the short term and as demand increases suddenly for long-term treasuries in a short time, their yield decreases, and vice versa with short-term treasuries. Therefore, during a recession, as the maturity increases, the yield decreases. When the short-term bonds have higher yields than those of the long-term bonds, the yield curve inverts and slides downward depicting speculations of a weakening economy.

Uncertainty is another factor that happens due to external shocks such as political turbulence, or pandemics where people halt their investment and consumption such as that of 2020 during the COVID-19 pandemic when economic activities all over the world were halted as tight restrictions were imposed to halt the spread of the pandemic. Oil shocks are the most common with financial crises shocks becoming more common recently, while monetary and fiscal policy shocks are the least common of all affecting smaller and more open economies, as seen in the below graph that shows the type of shock that probably caused the recession.

According to the NBER, there have been 34 recessions in the United States since 1857, ranging in duration from two months (February to April 2020) to more than five years (October 1873 to March 1879). The six recessions since 1980 have averaged fewer than 10 months in length compared to the average recession duration of 17 months. The stock market falls during a recession and they experience high volatility. Table 1 and Figure 1 below show the change in real GDP from peak to trough and the percentage change in the S&P500 peak to trough showing an average of –3% and –30%, respectively. The S&P 500 surprisingly increased by an average of 1% during all recession periods since 1945 as markets usually top out, meaning that they are at the end of a flourishing period and now can be expected to stay on a plateau before the start of recessions and bottom out before ending.

Table 1: Source: Romer, D (2019), RBC Capital Markets (2022)