Walden: Here’s how to understand the language of recessions

Editor’s Note: Dr. Michael Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University and a regular contributor to WRAL TechWire.

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RALEIGH – We frequently use terms and phrases in our language as shortcuts, and not just in our everyday language. So, what’s the language we use when economists discuss recessions? Let me translate.

Here’s why this matters, right now. Frequently, economics lingo seeps into everyday conversation, particularly in the media. We’re hearing many of these specialized terms today, as fears of an impending recession are becoming more frequent.

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When a recession ‘occurs’

When economists say a recession occurs, they mean total economic activity is “receding”—that is, declining.

A variety of factors are used to make this assessment, including total production of goods and services (called “gross domestic product, or GDP), employment, and income. A non-governmental entity, the National Bureau of Economic Research (NBER), officially makes the call on a recession. Traditionally, NBER has defined a recession only if the decline is for at least two quarters (six months), but this is not a rule.

Conversely, the NBER says a recession has ended when the decline in economic activity stops. Notice, this does not mean a recession ends only when economic activity returns to its pre-recession levels. Consequently, unemployment, for example, can remain elevated for several months or years even after a recession has been declared as “over.”

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Policy-specific language

Much of the economic language of recessions deals with policy.

The Federal Reserve—the central bank of the United States—often is the leader in dealing with ups and downs in economic activity. When the Fed “tightens” its policy, it is raising its key interest rate and reducing the growth of money in the economy. The Fed would tighten policy to slow economic activity in order to reduce inflation. If the Fed “loosens” its policy, it is doing the opposite—lowering its key interest rate and increasing money growth. The Fed follows this policy in a recession.

As implied by the previous paragraph, one of the challenges in an economy is balancing economic growth and inflation. If the economy grows too fast, inflation can jump. But if fighting inflation means slowing the economy, the worry is that “slow growth” can become “negative growth”—meaning a recession.

With the inflation rate now at a forty-year high, the Fed has started “tightening” their policy by increasing interest rates and slowing the increase in money. Their goal is a “soft-landing” of the economy, meaning the inflation rate is reduced without crashing the economy into a recession. The Fed was able to do this a couple of times in the 1990s.

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What’s the alternative?

The alternative result is a “hard-landing”; that is, inflation is moderated but only after a recession occurs. Obviously, the Fed doesn’t want this result, but sometimes it’s unavoidable. The last time inflation was higher than it is now—in the late 1970s and early 1980s—inflation was reduced, but only after a very severe “hard-landing.”

Since the possibility of an upcoming recession is a worry today, we’d all like to have an indicator that told us if a recession is coming or not. A recession indicator that has one of the best track records is the “yield curve.”

The yield curve compares the interest rate (yield) earned on a short-term financial investment to the interest rate earned on a long-term investment.

Usually, government bonds are used. Since there is more risk with a long-term investment, interest rates are normally higher with long-term investments. Hence, the “yield curve” is positive, meaning short-term investments have lower yields, while long-term investments have higher yields.

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When a yield curve ‘inverts’

But if investors worry about the future economic outlook, they will shift away from buying long-term investments to buying more short-term investments. This action will reduce long-term yields and increase short-term yields, thereby resulting in an “inverted yield curve.”

An inverted yield curve indicates investor worries about the future. While not infallible, if investors are worried about the future, then the likelihood of a recession is higher.

I expect that talk of a recession will continue in coming months. Will knowing the language allow you to better predict a recession? Like you, I’m still trying to decide!