By Mike Walden
We frequently use terms and phrases in our language as shortcuts. For example, in my youth the word “cool” was a shortcut for approval. To complicate matters, the shortcut terms often change over generations. Among today’s young people, “sick” or “dope” are the equivalents for “cool”. For a senior citizen like me, it’s hard to keep up!
It’s not just in everyday language that shortcuts are used. Most business sectors and even academic disciplines use them. Economics is a good example. As a professional economist for almost five decades, I’ve learned an entire language – or lingo – to describe concepts and actions in the business world.
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.
Hence, in today’s column I’ll give you translations of the economic language of recessions. With these translations at hand, you’ll be better able to follow the path of the economy, what a recession means and the implications of various policy actions.
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”.
Much of the economic language of recessions deals with policy. The Federal Reserve (the “Fed”) – the central bank of the country – 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 40-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.
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 tells 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.
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 the coming months. Hopefully, knowing the language of a recession will allow you to better understand the discussion. But will it allow you to better predict a recession? Like you, I’m still trying to decide!
Walden is a Reynolds Distinguished Professor Emeritus at North Carolina State University.