Each stage of the cycle reflects a different level of economic activity. By the time the business cycle passes through expansion and into the “peak,” we often see areas of the economy beginning to overheat. This happens when the economy starts to run at a pace that it can’t sustain. There simply isn’t enough supply to meet all the demand. This often fuels inflation, as scarce supply can drive prices up.
In response, central banks like the Bank of Canada or U.S. Federal Reserve may raise interest rates. This is called tightening monetary policy. It’s designed to slow consumer spending and bring economic activity back into balance.
What typically follows is a recession, as tighter conditions often reduce demand for goods and services. As consumers spend less, this impacts how much companies produce, their willingness and capacity to hire, and ultimately leads to a general slowdown in economic activity.
Do all recessions follow the same path?
No. The causes of a recession tend to affect its length and depth. For example, there was a recession in 2020 at the height of the COVID-19 pandemic. It was exceptionally deep, due to the widespread lockdowns. But it didn’t last long in many countries due to the actions of government and central banks, and the rapid reopening of economies.
The recession that happened with the 2008 financial crisis was different. It was caused when excess borrowing met with rising interest rates. This added to other issues in the housing market as people began to default on their mortgages. The resulting credit crisis spread globally and took years to resolve. Compared to typical recessions, the 2008 financial crisis was both exceptionally deep and long.
Whatever lies ahead for the economy, we know that business cycles will continue to come and go. So will recessions. They are an uncomfortable part of the business cycle.
How do recessions affect investors?
Recessions and bear markets tend to go hand in hand. Investors will often feel short-term pain. But recessions don’t usually disrupt investors over the long term. As you can see in the chart below, historically markets have risen over time.
U.S. recessions and equity bear markets go hand in hand