Inflation Vs. Recession: What Is The Difference?

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 Australia, a common measure of inflation is the consumer price index (CPI), which measures the change in price of 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 supermarket prices to petrol for your car, high inflation means everyday essentials become 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. Hospitality businesses in Australia are particularly exposed to the twin pressures of lower customer demand, but higher running costs. As of November, 2024, CreditWatch estimates a closure rate of 8.9% over next 12 months for the sector.

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.

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. While the Reserve Bank of Australia says there is no single definition, it does say a recession often involves a sustained period of weak or negative growth in real GDP (as opposed to per capita) accompanied by a significant rise in the unemployment rate.

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. One of the more positive aspects of Australia’s economy right now is the reasonably low levels of unemployment, which is sitting at 4.1% as of November 2024. This means that although consumers are feeling the weight of successive interest rate rises and higher prices, they’re able to afford them for the most part.

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 labour. 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 can even exceed where it was before the economic decline began.

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 RBA is too slow to lower interest rates as inflation comes down, there’s a risk that they may miss the “narrow landing” the Board talks about and the country could move into 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 labour, causing the economy to produce less.

It can be difficult to decide which is worse: 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 you can make informed decisions about how to manage your finances and investment portfolio during times of rising inflation or a recession.