What Causes a Recession?

The National Bureau of Economic Research (NBER) defines a recession as a significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale retail trade.

A recession is caused by a chain of events in the economy, such as disruptions to the supply chain, a financial crisis, or a world event. A recession can also be triggered after an inflationary period. When inflation increases, central banks raise interest rates to slow the economy with the goal of bringing down inflation. With higher interest rates, the probability of a recession increases, leading to layoffs, fewer jobs, and decreased consumer and corporate spending, among other effects found in a slowing economy.

As companies and consumers become anxious about the economy, they hold on to their money and cut spending. Businesses are forced to reallocate resources, scale back production, limit losses, and lay off employees as the economic downturn intensifies. Trends during a recession include an increase in the unemployment rate and a decrease in gross domestic product (GDP) for two consecutive quarters.

Signs of a Recession

The standard macroeconomic definition of a recession is two consecutive quarters of negative GDP growth. When this occurs, private businesses often scale back production and try to limit exposure to systematic risk. Measurable levels of spending and investment are likely to drop, and a natural downward pressure on prices may occur as aggregate demand slumps. GDP declines, and unemployment rates rise because companies lay off workers to reduce costs.

At the microeconomic level, firms experience declining margins during a recession. When revenue—whether from sales or investment—declines, firms look to cut their least efficient activities. For example, a firm might stop producing low-margin products or reduce employee compensation. It might also renegotiate with creditors to obtain temporary interest relief. Unfortunately, declining margins may force businesses to reduce employment to cut costs further.

Causes of Recession

The significant economic theories of recession focus on financial, psychological, and fundamental economic factors that can lead to the cascade of business failures that constitute a recession. Some theories look at long-term economic trends that lay the groundwork for a recession in the years leading up to it. Others look only at the immediately visible factors that appear at the onset of a recession. Many or all of these various factors may be at play in any given recession.

Financial factors can contribute to an economy’s fall into a recession, as during the 2007–2008 U.S. financial crisis. The overextension of credit and debt on risky loans and marginal borrowers can lead to an enormous buildup of risk in the financial sector. The expansion of the supply of money and credit in the economy by the Federal Reserve and the banking sector can drive this process to extremes, stimulating risky asset price bubbles.

Artificially suppressed interest rates during the boom times leading up to a recession can distort the structure of relationships among businesses and consumers. It happens by making business projects, investments, and consumption decisions that are interest rate-sensitive, such as buying a bigger house or launching a risky long-term business expansion, appear much more appealing than they ought to be. The failure of these decisions when rates rise to reflect reality constitutes a major component of the rash of business failures that make up a recession such as that of 2007–2008.

Psychological Factors of a Recession

Psychological factors are also frequently cited by economists for their contribution to recessions. The excessive exuberance of investors during the boom years brings the economy to its peak. The reciprocal doom-and-gloom pessimism that sets in after a market crash, at a minimum, amplifies the effects of real economic and financial factors as the market swings.

Moreover, because all economic actions and decisions are always forward-looking to some degree, the subjective expectations of investors, businesses, and consumers are often involved in the inception and spread of an economic downturn.

Economic Factors of a Recession

Real changes in economic fundamentals, beyond financial accounts and investor psychology, also make critical contributions to a recession. Some economists explain recessions solely due to fundamental economic shocks, such as disruptions in supply chains, and the damage they can cause to a wide range of businesses.

Shocks affecting vital industries such as energy or transportation can have such widespread effects that they cause many companies across the economy to retrench and cancel investment and hiring plans simultaneously, with ripple effects on workers, consumers, and the stock market.

There are economic factors that can also be tied back into financial markets. Market interest rates represent the cost of financial liquidity for businesses and the time preferences of consumers, savers, and investors for present vs. future consumption. In addition, a central bank’s artificial suppression of interest rates during the boom years before a recession distorts financial markets and business and consumption decisions. All of these factors may cause a recession over time.

In turn, the preferences of consumers, savers, and investors place limits on how far such an artificially stimulated boom can proceed. These manifest as economic constraints on continued growth in labor market shortages, supply chain bottlenecks, and spikes in commodity prices (which lead to inflation). When not enough resources can be made available to support all of the business investment plans, a rash of business failures may occur due to increased production costs. This situation may be enough to tip the economy into a recession.

Impact of COVID-19 Pandemic on the Economy

In February 2020, the National Bureau of Economic Research (NBER) announced that, according to its data, the United States was in a recession due to the economic shock of the widespread disruption of global and domestic supply chains and direct damage to businesses across all industries. These events were caused by the COVID-19 epidemic and the public health response.

Some of the underlying causes of the two-month recession (and economic hardship) in 2020 were the overextension of supply chains, razor-thin inventories, and fragile business models.

The pandemic-related recession, according to NBER, ended in April 2020, but the financial hardship caused by the pandemic is still affecting Americans.

Current Risks of Recession as of November 2022

In the current environment, we find the Federal Reserve (and other major central banks) raising interest rates aggressively to combat inflation, which at 6.2% in the U.S. remains well above the Fed’s target for inflation of around 2%. The Fed has increased rates by 0.75% increments at each meeting since April 2022, bringing the federal funds target rate to 3.75% to 4.00% since then. At the moment, debate rages about whether the U.S. is currently in a recession or whether a recession is coming down the road in 2023.

The case for the U.S. currently being in recession is undermined by a number of recent positive data points, namely:

• Annualized third quarter (3Q) GDP growth of 2.6% offsetting negative GDP reports in Q1 and Q2
• A strong job market in which jobs are still rising
• The October 2022 unemployment rate remaining historically low at 3.7% (although up from 3.5% in September).

However, other indicators—such as an inverted yield curve, which has historically been a precursor to recessions—coupled with the lagged effect of interest rate hikes (around six months’ lag time) suggest a less-than-sanguine outlook for 2023. The Fed is currently expected to begin to slow the pace of its interest rate increases in the months ahead, aiming for a final fed funds target rate of 5%, also referred to as the terminal rate.

Higher interest rates make everything from home mortgage rates to credit card rates rise, which eats away at consumer spending, ultimately the the key driver of U.S. economic activity. Looking ahead, the debate centers on whether the Fed can deliver a soft landing (lower inflation and a minor slowdown in the U.S. economy), or whether the series of rate hikes may lead to a hard landing (where inflation comes down at the expense of economic growth and employment), which could result in a recession.

Our view is that the Fed will succeed in engineering a soft landing, where inflation begins to subside (disinflation) as higher rates work through the economy, slowing economic growth, but not enough to cause a recession. We will continue to pay special attention to the state of consumer spending, unemployment, and job creation as the main bellwethers of a recession.

Of note, there are a number of exogenous factors, such as the Russia-Ukraine war, which could result in sustained higher oil and natural gas prices and a further loss of grain supplies. This in turn could further undermine the global economy, which would result in increased pressure on the U.S. and other major economies. These type of factors will need to be monitored closely as we head into the winter, where we will view seasonal factors as mainly noise and continue to focus on the key consumer and employment data.

The Bottom Line

Recessions are caused by a multitude of factors, with higher interest rates usually cited as the primary cause of a recession. At the moment, the market is also concerned with nonroutine events, such as the Russia-Ukraine war and its impact on energy and commodity prices, which have fed into higher inflation. To combat inflation, the Fed and other central banks have been aggressively raising interest rates to bring inflation down to their target of around 2%.

In raising short-term interest rates, now at 3.75% to 4.00%, the Fed may be overly aggressive and overshoot an interest rate that is appropriate to bring down inflation, sending the economy into a recession. The hope is for a soft landing, where interest rates reach a level to bring down inflation and avoid a recession. The alternative is a hard landing, where the Fed raises rates too much and triggers a recession.