Australia looks set to follow world markets into a recession off the back of high inflation in part caused by cheap credit and spikes in commodity prices.
This is leading to central banks around the world lifting rates. But it's a balancing act. These banks need to lift rates fast enough to slow down inflation, but not raise them enough to slow consumer spending or impact businesses. If rates continue to rise by too much, it is likely to tip Australia into a recession.
In Australia, the Reserve Bank of Australia (RBA) has lifted rates by 50 basis points over the last 2 months, increasing fears that the economy as a whole will slow.
While in the US, the Atlanta Federal Reserve is stating the US economy is already in a recession. And as the old saying goes, when the US economy sneezes, the rest of the world catches a cold.
This guide will explain what a recession is, why no recession is the same and why it is a usual part of the economic cycle.
A recession is a macroeconomic term that describes a significant decline in economic activity, usually situated by country or region.
In Australia, this is measured by 2 negative quarters of economic decline, as measured by a fall in gross domestic product (GDP).
GDP is a measurement of what a country produces minus imports over a set time. In Australia, it is measured quarterly by the Australian Bureau of Statistics (ABS).
In order to calculate this figure, the ABS collects information about production (the total value added of goods and sold produced), income (total income generated by employees and businesses plus taxes minus subsidies) and expenditure (by consumers, businesses and government on final goods and services).
A simpler measure for GDP is aggregate demand. This is simply consumption plus investment plus government spending plus (export minus import). In countries like Australia and, in particular, the United States, consumption is the largest input to GDP.
The current rhetoric around recession fears in Australia and much of the developed world is due to spiking inflation.
COVID-19 downturns saw world economies print money while consumer spending fell due to lockdowns.
With economies re-opening, cheap credit and a surge in consumer demand, the prices of items are rising. Add to it supply-side shocks, including bottlenecks in shipping, and a spike in commodity prices in part due to the conflict in Ukraine and we have surging inflation.
To fight this, the RBA is drastically lifting rates.
It hopes that by making you pay more for your mortgage and businesses paying more to service debt, it'll slow down spending.
But if it slows down spending too much, it will tip the economy into a recession.
Looking to prepare your portfolio for a recession? here's how.
There's no shortage of doom and gloom predictions on the Australian market.
But even with a record high participation rate and record low unemployment, Aussies are still feeling pessimistic about the country's future.
According to Finder's consumer sentiment tracker, fears of a recession are at their highest level since November 2020.
Now this could become a self-fulfilling recessionary prophecy. If Australian consumers continue to feel pessimistic about their long-term outlook, they will drop spending. Given household consumption makes up around 50% of Australia’s GDP, consumer sentiment could be key for whether Australia avoids a recession.
Unfortunately, it is incredibly difficult to predict the next recession because recessions are not the same.
Take, for example, the current inflation rate rises that the economy currently faces.
Some might say we have faced them before in the 1970s and 1990s, but the cause of inflation was different.
In the 1970s, it was off the back of surging oil prices, and in the 1990s, it was because of surging consumer spending.
While both are true today with the market facing a "perfect hurricane", the situation around COVID-19, supply bottlenecks and unrest in Europe are different circumstances than those in the 1970s and 1990s.
Then there are collapses, which are spiked by a completely different set of circumstances.
The great recession in 2008 was, for example, a collapsing property market. This was the most serious recession since the great depression of 1928.
In this case, it was lax lending standards and increasing risks taken by financial institutions that led to a United States housing bubble. When it burst, the American real estate market fell and the financial institutions lending to them nearly collapsed. This climaxed with the bankruptcy of the Lehman Brothers, which eventually spread across the world.
For those that don't remember, in Australia, the government guaranteed the first $250,000 in savings to stop consumers from withdrawing their funds. This guarantee still exists today.
Unfortunately, recessions are a normal part of any economic cycle, even if Australia has avoided these downturns for the most part.
Australia has just been the lucky country. If you were born in the late 90s or later, you've only experienced one downturn in your life and that was during the COVID-19 pandemic.
Prior to the 2020 downturn, Australia had 29 years of uninterrupted economic growth, with its last recession in 1991.
But Australia's past has been the exception, not the rule.
If you go all the way back to 1857, economies on average enter a recession every 3 and a quarter years.
The United States, for example, has gone through 11 recessions since 1948.
While most recessions start with an unknown event, which economists have dubbed a "black swan", that doesn't mean there's no indication of an upcoming recession.
They all have the same general patterns that you can pick up on. Economists generally look out for the following:
What is an inverted yield curve?
One of the clearest indicators investors use to pick an upcoming recession is what is known as an inverted yield curve.
If you watch the bond markets, typically you'd expect to see rising interest rates over time.
This is because investors want to be compensated for having their money tied up. Also, partly due to inflation, it's a riskier investment to have your money in a long-term asset.
An inverted yield curve is when the short-term debt instrument has higher yields than the long-term debt instrument.
If you see this, the debt markets are predicting a decline in the longer-term interest rates.
This can be a sign of an upcoming recession because central banks cut rates in slowdowns.
Inverted yield curves have predicted 7 of the last 8 recessions with no false predictions. In 2022, world markets had inverted yield curves.
As such, this is a prediction that a recession is coming in the next 2 years.
While there's no formal definition of a depression, it's generally agreed upon in economics to be a more severe version of a recession.
This is because of the time frame.
A recession usually lasts a number of months, while a depression goes on for years. The great depression that started in 1929 went through to 1939. This was in part due to banks and monetary policy contractions, which is the opposite to how central banks deal with downturns today.
By now you know that not all recessions are the same, but the response for the most part is fairly similar.
The way governments respond to downturns today is a combination of fiscal and monetary policy.
In most world governments, the fiscal response will include increasing government spending to support consumer demand and to get people back to work.
Central banks will loosen monetary policy by lowering interest rates and, in some instances, printing money.
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