Does Inflation Cause a Recession?

Recession and inflation are closely linked economic events, each influencing the other in various ways. Inflation, a general increase in prices over time, can reduce consumer purchasing power, making goods and services more expensive. When inflation rises too quickly, central banks may increase interest rates to slow down spending and borrowing, aiming to control inflation. However, these rate hikes can reduce business investments and consumer spending, which sometimes triggers a slowdown or recession. While inflation does not directly cause a recession, prolonged high inflation rates combined with tightening monetary policies can contribute to economic contraction.

A financial advisor can help you adjust your financial plan for inflation and potential recessions. Find a financial advisor who serves your area.

What Is Inflation?

Inflation is the rate at which goods and services get more expensive across the economy. When prices rise overall for equivalent products, this is known as inflation. The reverse happens in deflation, which is when prices fall for equivalent goods and services.

For example, say a gallon of milk costs $4. If across the country, milk rose to $4.40, that would be considered 10% inflation. If the price of milk rose in a single area, or if stores started charging $5 for 1.5 gallons of milk, that would not be considered inflation.

Inflation generally occurs when demand and production meet a bottleneck. Consumers have more spending power and can therefore outpace the economy’s capacity to produce. Ordinarily, when consumers get wealthier, businesses produce more goods and services to keep up with demand. When businesses can’t produce new goods and services, but demand continues to grow, they raise their prices.

This can happen many different ways, but often it’s the result of disproportionate elasticity in the market. Either consumers get wealthier faster than businesses can grow to keep up, or productive capacity falls faster than money can leave the economy.

In the wake of the coronavirus, economists believe consumer wealth beat business growth and productivity fell faster than spending. Generous government support programs stimulated the market with cash at the same time as the pandemic disrupted production and logistics worldwide. This left a highly liquid consumer population trying to buy things from businesses with significantly reduced productive capacity, which has caused inflation.

Economists worry about inflation more than most economic disruptions because it can become a self-sustaining cycle. Higher prices cause workers to demand higher wages to keep up with the new market. Higher wages mean higher costs for businesses, which charge higher prices to compensate. Higher prices draw more money from workers, who need higher wages in response. This cycle can feed back on itself and once it begins, it can be very difficult to stop.

How Does Inflation Affect Consumers?

A woman adjusting her budget to account for inflation.

A little bit of inflation can actually be a good thing. This is important to understand because inflation is almost universally reported as being a negative thing. In a healthy economy, inflation tends to indicate that consumer spending power is growing faster than the economy’s ability to keep up. This can encourage economic growth and new business formation, as companies try to keep up with rising demand. That, in turn, correlates with rising wages and productivity. This is why the Federal Reserve’s target rate of inflation is 2%, not zero. Some price growth is a good thing.

The problem is degree of inflation. A little bit of price growth can encourage business formation and erodes fixed-interest debt, as loans lose value relative to the value of money. However, inflation also makes goods and services more expensive for consumers. If inflation gets too high it can make it harder for consumers to afford the same quality of life. They have to spend more and work harder just to buy the same things. At best, high inflation causes people to cut back on luxuries. At worst, they struggle to afford necessities.

Inflation’s Impact on Interest Rates

Higher inflation also affects borrowing costs. When inflation rises, central banks often raise interest rates to control it, making loans for homes, cars, and credit card debt more expensive. Consumers face higher monthly payments on new or variable-rate loans, which can limit their financial flexibility. For those with significant debt, the combination of higher prices and increased loan payments can place additional strain on their finances, leaving less money available for savings or investments.

Inflation’s Impact on Retirement

Inflation can also impact long-term financial goals like retirement savings. As inflation erodes the purchasing power of money over time, consumers may need to save more to achieve the same financial goals.

For example, a retirement fund set up years ago might not provide as much security if inflation consistently outpaces investment growth. By understanding how inflation affects daily expenses, borrowing, and long-term savings, consumers can make informed decisions about their budgets, spending, and investments.

What Is a Recession?

A recession is an economic downturn marked by a sustained decline in economic activity, typically measured over at least two consecutive quarters. Indicators like gross domestic product (GDP), employment rates, consumer spending, and industrial production are closely monitored to determine if an economy is contracting. When GDP shrinks over multiple quarters, along with rising unemployment and decreasing consumer and business spending, a recession may be declared.

Recessions are often characterized by lower business profits, job losses and reduced consumer confidence, all of which contribute to a cycle of decreased spending and investment. However, while the “two consecutive quarters” definition is widely used, official determinations are made by institutions like the National Bureau of Economic Research (NBER) in the U.S., which considers a variety of factors to confirm a recession.

Not every economic slowdown qualifies as a recession. For instance, temporary declines in certain industries or short-lived economic contractions may not meet the criteria. A recession must reflect a broader, sustained economic decline, typically with far-reaching impacts on employment, income, and consumer behavior.

How Are Inflation and Recessions Connected?

Inflation and recessions are interconnected through the broader economic cycles that influence spending, borrowing and investment behaviors. When inflation rises quickly, central banks often respond by raising interest rates to curb consumer spending and slow the economy. Higher interest rates can increase the cost of borrowing for businesses and individuals, which tends to reduce investment and spending.

As this slowdown occurs, businesses may see lower sales, potentially leading to layoffs and reduced hiring, which can contribute to a downturn or recession.

Ideally, by slowing down economic activity as a whole, the government can reduce demand relative to the economy’s productive capacity. This can give prices a chance to stabilize. Although critics have pointed out that raising interest rates makes it harder for businesses to respond to inflation by building new capacity, which would also help reduce inflation.

Historically, prolonged periods of high inflation, also known as stagflation when combined with stagnant economic growth, have sometimes led to recessions. For example, during the 1970s, the U.S. faced both high inflation and rising unemployment, eventually resulting in a recession. When prices outpace wage growth, consumers’ purchasing power weakens, leading to decreased demand for goods and services. This decreased demand can slow down economic activity, potentially tipping the economy into a recession if conditions persist.

Recession isn’t inevitable in the face of inflation, but it is common and hard to avoid.

How to Protect Your Finances During Inflation and a Recession

To protect your money during inflation and a recession, start by reviewing your monthly budget. Cut back on non-essential spending like dining out, subscriptions, or luxury purchases. Use that extra money to boost your savings or pay off debt.

Next, build or grow your emergency fund. Aim to save enough to cover at least three to six months of essential expenses such as rent, food and utilities. Keeping this money in a high-yield savings account allows you to earn interest while still having quick access in case of job loss or unexpected bills.

Once your basic savings are in place, take a closer look at your investments. During a recession or periods of high inflation, it’s wise to shift toward more stable options. Sectors like healthcare, utilities and consumer staples often hold up better. Adding bonds, dividend-paying stocks, or real estate investment trusts (REITs) can help reduce risk and provide steady income.

Finally, focus on paying down high-interest debt. Inflation can lead to higher borrowing costs, so lowering or eliminating credit card balances and variable-rate loans can free up more cash each month. Use any extra income, such as a tax refund or bonus, to make faster progress on your debt. This will give you more financial breathing room moving forward.

Bottom Line

A woman reviewing her bills during a recession.

Inflation causes prices to rise, which can slow down an economy somewhat as both raw materials and labor gets more expensive. However the real connection between inflation and recessions is in the cure. Governments try to reduce inflation by slowing down the economy. When things get too slow, a recession can set in and in some cases deflation.

Tips for Investing During Inflation

A financial advisor can help you adjust your financial plan to protect investments from inflation and interest rate hikes. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you want to know how much an investment can pay, SmartAsset’s free investment calculator can help you get an estimate.