Written by: Kat Tretina, August 30, 2022, https://www.forbes.com/advisor/investing/inflation-vs-recession/

If you’ve been watching the news lately, you might be more that a little concerned about the U.S. economy. From rising inflation to recession fears, there is a lot of talk about negative economic conditions. Inflation and recession are important economic concepts, but what do they really mean? Let’s take a closer look at their differences.

What Is Inflation?

Inflation is a measure of the gradual, broad increase in prices throughout the economy. It’s usually expressed as a percentage, which represents the rate at which the costs of goods and services have increased over the last year.

A minimal level of inflation is expected and even encouraged. But it becomes a problem if the inflation rate gets too high. In the U.S., a common measure of inflation is the consumer price index (CPI), a basket of items consumers often purchase. This basket includes food, housing, clothing, transportation and health care.

Excessive inflation can severely impact the economy. From grocery store prices to gas for your car, high inflation means everyday essentials are becoming much more expensive.

As prices rise, consumers have less money to spend on goods and services. People adjust their financial habits, which in aggregate, can slow down economic growth throughout the economy, potentially leading to higher unemployment. Businesses may see lower demand and higher costs.

What Causes Inflation?

So what causes inflation? There are several factors:

• Cost-push inflation. This happens when the prices for the key inputs of goods and service rise, such as raw materials and labor. When companies have to pay much more for inputs, they pass on the costs to consumers in the form of higher prices.
• Demand-pull inflation. When there is too much money and demand chasing too few goods, it can push up inflation. It can be caused by increased government spending or a tax cut that puts more money into people’s pockets. When there is more demand for goods than supply, prices will go up.
• Inflation expectations. Anticipating future price gains can lead people and businesses to expect higher inflation. As a result, workers may ask for higher wages to offset the increased cost of living—but this loop may create a self-fulfilling prophecy: Fears about inflation deepen the problem.

What Is a Recession?

A recession is an economic downturn, typically defined as two consecutive quarters of declining gross domestic product (GDP) growth. Generally, when the economy shrinks for six months or more, it’s considered a recession.

That said, the official definition of a recession is a bit more involved. In the U.S., the National Bureau of Economic Research (NBER) is tasked with judging the starting and ending dates of recessions. Its recession definition is a “significant decline in economic activity spread across the economy,” lasting more than a few months, as seen in the data for GDP, income, employment, industrial production and sales.

During a recession, unemployment rates increase, wages may stagnate and people usually have less money to spend. Those factors mean there is less demand for goods and services, which can further hurt the economy.

What Causes a Recession?

Recessions are caused by the following developments:

1. Decreased consumer spending. When people have less money to spend, they purchase fewer goods and services. This decreased demand can lead to businesses reducing production, which leads to layoffs and increased unemployment.
2. Increased business costs. Businesses may be forced to raise prices to offset higher costs, such as the cost of materials or labor. This can lead to inflation and decreased consumer spending.
3. Reduced lending. When banks are reluctant to lend money, it can impact businesses’ ability to expand or invest in new projects. This reduced lending can lead to a decrease in economic growth.
4. Stock market declines. A decrease in stock prices can contribute to a recessionary environment by reducing the wealth of individuals and businesses. This can lead to less spending and investment, further slowing the economy.

Recessions are normally pretty brief. On average, recessions last for about 10 months. Then the economy usually recovers and even exceeds where it was before the economic decline began.

Inflation vs. Recession: Which Is Worse?

Inflation and recessions are very different economic phenomena, but they are intrinsically linked.

High inflation rates can indicate an impending recession, as businesses react to higher costs by reducing production and increasing prices. And if the Federal Reserve takes action in the form of more rate hikes to curb rising inflation, there’s a risk that the move could help trigger a recession.

According to the Economic Policy Institute, economists’ opinions vary on which is worse for an economy, a recession or rising inflation. One common argument is that inflation is worse than a recession because it impacts everyone. By contrast, a recession—and the associated job losses that come with it—may impact a smaller number of people.

However, opponents of that school say recessions reduce the income of everyone throughout the economy. With unemployment during a recession, there is also a loss of productive resources, particularly labor, causing the economy to produce less.

It can be difficult to decide which is worse for the economy: inflation or recession. Both negatively impact different aspects of economic life, such as consumer spending and lending.

But by understanding the differences between these two conditions to make informed decisions about how to manage your finances and investment portfolio during times of rising inflation or a recession.