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The link between inflation and recessions

Key takeaways

  • Inflation measures how much prices are rising over time.
  • A recession is a period of negative economic growth.
  • An emergency fund could give you a financial cushion in down markets brought by inflation and recessions.
  • Diversifying your investments could help reduce your risk when inflation is high.

Like the ocean, the economy naturally moves in waves—2 of which are inflation and recession. During inflation, prices for goods and services increase. During recessions, the economy slows, and unemployment often rises in response. Here's what you need to know about inflation vs. recession and how they're related, plus tips to prep your finances for rough economic waters.

What is inflation vs. recession?

While you might notice rising prices on specific things you frequently buy in your area, inflation measures how much prices rise across the board in many locations. It's generally a percentage reflecting how much prices have spiked over the last year.

"When people hear inflation, they automatically think ‘bad,'" says Collin Crownover, a research analyst at Fidelity Asset Allocation Research. But a little inflation is healthy. When demand for goods and services climbs, and prices rise too, companies make more money and can hire more workers and pay them more.

However, if inflation surges well past the Federal Reserve's target annual inflation rate of 2%, you might feel the pain in your finances. Paying more for things you need means there's less money in your budget to save and buy things you want. As a result, you may spend less and companies may profit less. If everyone's tightening their belts, economic growth can slow and unemployment can rise because companies can't afford to keep paying their whole workforce's wages. This could play a part in a recession.

A recession is a period of continued negative economic growth. It can happen because of wars or pandemics, an industry collapse (hello, 2008 housing market), even an overheated economy (or when the economy is growing too quickly).

A recession isn't the economy having just one lousy month or a TV talking head announcing a recession is here. Instead, the National Bureau of Economic Research (NBER)—a nonprofit, nonpartisan economic research organization—gives the official word on whether the country is in a recession. It makes the call by reviewing data across several parts of the economy, typically over several consecutive months. Fortunately, recessions can be short-lived, such as the COVID-19-induced 2020 recession, which lasted only 2 months.

During a recession, companies typically lay off workers to trim costs, and concerned shareholders may cash out of the stock market and send stock prices down—even though, historically, the stock market has recovered after each recession and grown over time. While stocks may decline in recessions—and they fall sharply during bear markets—the 2 aren't the same. A recession takes into account the entire economy's lack of growth, while a bear market is defined as a decrease of 20% or more in stock prices from recent highs. In theory, you can have a recession without a bear market, as well as a bear market that doesn't lead to or occur during a recession, even if the 2 are often correlated.

Inflation vs. recession: Does one cause the other?

Inflation can cause a recession in some instances, such as:

  • If inflation spurs consumers to cut spending too much. Less money in the economy means lower revenues and potentially negative growth for businesses.
  • If the Fed raises interest rates too much to rein in inflation. Higher interest rates can clamp down on companies borrowing money to try to grow. And they can cause people to take out fewer mortgages and auto loans, cooling industries too much.
  • If wages don't keep pace with inflation. Crownover says that wage growth typically outpaces inflation, but if it doesn't, consumers tend to cut back on discretionary spending, which can hurt the economy.

Does inflation typically rise during a recession?

Not usually. During a recession, economic activity slows. When consumers spend less, the demand for goods and services falls. Once that happens, prices tend to drop, slowing down inflation.

But there are exceptions. It's possible for inflation to rise during a recession, as it did in the 1970s. That's when gas prices shot up because the Organization of Petroleum Exporting Countries (OPEC) cut off shipments to the US during a war between Israel and its neighbors. When there's inflation during a stagnant economy, it's called stagflation. Luckily, stagflation is rare.

How to manage inflation and recessions

Even though it is incredibly difficult to predict when there will be high inflation or a recession, these tips could help prepare your finances to withstand stressful economic conditions.

Have a plan

We're emotional creatures, and emotion—especially when it comes to money—could lead to unwise decisions. Having a financial plan with clear goals could prevent emotional decision-making and help you:

Whether your current plan needs a tune-up or you need to craft one for the first time, a financial professional could help.

Build up your emergency savings

A cash cushion can help protect you across all of the economy's moods. When inflation rises, an emergency fund may offer an accessible pool of cash that could help ease the pain of rising prices. Having a stash of cash could also prevent you from taking on higher-interest debt on credit cards just as interest rates spike in inflationary times. During a recession, extra savings could help tide you over if you lose your job and buy you time to find your next career opportunity.

Evaluate your spending

When the economy pressures your wallet, a budget can be your best friend. It can give you a clear picture of your monthly income and expenses and could help you quickly identify places to save. Trimming expenses doesn't mean cutting out all the fun. It just means finding opportunities to spend less in certain areas. But consider continuing to save for retirement and keeping your emergency fund untouched—those moves could benefit you in the long run.

Assess your investments

Inflation can weaken your buying power, especially if high prices stick around for a long time. Check your investing strategy when that happens. A well-diversified portfolio—with no single investment type being a huge slice of your overall pie—could soften the blow of market volatility when prices rise or a recession hits. Different investment types may react differently to inflation and recessions.

You could also review your portfolio to ensure you're taking on an appropriate level of risk for your retirement time horizon. Generally speaking, the longer you have until retirement, the more risk you could afford to take on. The opposite is true too: The closer you are to retirement, the less time your investments have to recover from losses, so a more conservative investment strategy may be a better fit.

Have patience

Uncertainty can lead you to do what you shouldn't, like buying high and selling low. That's why Crownover says a good guideline for inflation and recessions is "don't make permanent decisions based on temporary conditions." Historically, recessions last less than a year. Inflation's timeline is a bit trickier, as prices don't tend to fall as quickly as they rise. No matter how long inflation or a recession lasts, having a financial plan, emergency fund, and budget could help position you for smoother sailing when economic waters get rough.

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