How to differentiate between inflation and recession, and how to react in either situation
Good ole inflation! From your cup of coffee to the gas pump, pet grooming or a new winter coat, you’re always paying more for products and services. Economists closely monitor these price hikes, and once in a while, they will mention a potential recession or sometimes even a stagflation (when the economy is stagnant combined with high price increases).
Let’s compare inflation and recession, and place them in the context of your personal finances: How should you react when the economic forecast calls for stormy weather?
A better understanding of inflation
The Bank of Canada defines inflation as a persistent rise in the average level of prices over time. Between 1 and 3% is considered normal.
Economists often measure inflation using the Consumer Price Index (CPI). They use a realistic “basket” to show the evolution of costs paid by households for transportation, groceries, clothes, etc.
Where does inflation come from?
The are many causes for inflation, including:
- Supply and demand – When there are more buyers than available products, prices go up. Many sectors are also experiencing distribution issues on top of it.
- Labour shortage and salary increases – Many companies have trouble recruiting staff. They’re countering this problem by offering more attractive salaries. As a result, in most cases, they increase their rates to even things out.
- Increases that cause more increases – For example, restaurants pay more for food (just like we do), so their profit margins shrink, causing them to increase prices on their menu in order to remain profitable.
Impact of inflation
There are many consequences stemming from inflation. Here are a few major ones:
- When the cost of nearly everything increases, your dollar doesn’t go as far. You need more money just to maintain the same purchase power. Unsurprisingly, people whose income remains stagnant, such as retirees, are most impacted.
- Since increases create insecurity, consumers and companies will sometimes opt to put off some expenses or projects. For a household, it could mean delaying the arrival of a child, a return to school, buying a first house, etc.
Interest rates increase because the policy interest rate set by the central banks also increase. Their adjustments slow down economic activity in hopes of controlling inflation. For consumers, this often means that a mortgage or any other loan will cost more in interest.
Better understanding recession
A recession occurs when economic activity declines for 6 straight months in most sectors. It’s measured using the gross domestic product (GDP). This disruption also impacts the work market and causes job losses.
A recession may occur in certain countries, but global recessions like the one we experienced in 2020 are exceptional circumstances. Reassuring fact: Recessions are temporary, usually lasting less than a year. Sooner or later, the economy rebounds.
How does a recession occur?
They can be caused by a variety of things, such as:
- Inflation and an increase in interest rates
- Decreasing government investments
- Stock market crash
- Economic turmoil due to a major event such as war, a natural disaster or pandemic
- A decrease in household spending
What are the consequences of a recession?
When a recession sets in, unemployment rises and income tends to plummet. To offset this, the Canadian job market has grown significantly since the end of the pandemic, so no worries there.
Another recession would probably cause the following:
- Consumers and businesses would cut their expenses.
- Savings and investments would yield smaller returns.
- Households or businesses whose incomes decrease will have to go into debt to pay off bills.
How to prepare yourself financially
Inflation is a reality right now. Recession or not, we have to learn to adapt.
- Prepare an emergency fund you can use to get by for at least 3 months. It will help you avoid getting into debt during hard times. Put the money in a savings account or a TFSA and increase your deposit amounts as soon as you’re able.
- Update your budget (or prepare one): Inflation will cause you to go over your expenses often.
- Have a strategic plan for paying back your debts or try to bundle them with a lower interest rate.
- Plan all your purchases, more than before.
- Invest each month so you can take advantage of a bearish market. Every penny counts. If necessary, check out how you can save for your RRSP on a tight budget.
If you have stocks or investments, you’ll need a strategy.
- Avoid updating your portfolio when your investments drop. You’ll be losing money if you sell low, and miss out on potential gains when the market rebounds.
- Make sure your investments are diversified and that their average return over the long run is greater than inflation rates.
Your best bet is to contact a financial advisor who can help you build a personalized strategy based on your investment profile.
Keep a cool head
Inflation and recession are like economic storms. We live through them to varying degrees and at different times.
So it’s best be prepared so you can weather these storms and enjoy the calm seas. In finance you can be sure that after the storm, there is always sunshine.