Updated: Sep 27, 2022
I was recently featured in an article in Forbes Advisor discussing strategies to strengthen your finances before a recession hits. Just like the waves at sea, there are also waves in our economy. Unfortunately, predicting economic cycles is a much harder task than the daily tides. However, that is not to say that we cannot take stock of general indicators and levels to assess where we may currently stand in a cycle.
Historical stimulus efforts from both the Federal Reserve and Congress in the wake of Covid-19 pandemic has left the US economy running red hot as consumers have spent record amounts. These efforts, alongside global supply chain issues, have led inflation to spike to a 40-year high. As of March 2022, the most recent CPI-U measured a 12 month increase of 8.8%.
The Federal Reserve has embarked on tightening monetary policy, increasing interest rates in an attempt to cool inflation and the economy. While their goal is to navigate a “soft landing” - tighter financial conditions ultimately increase the probability of a recession in the next 24 months. This risk can most notably can be seen in the recent inversion of the yield curve, where shorter term interest rates went higher than longer-term rates. This inversion has accurately predicted 10 out of 11 recessions since 1955, according to a research report from the Federal Reserve Bank of San Francisco.
It is important to remember that recessions come in all different types. With different causes, severity, and ultimately lengths. Also, a recession is far from set in stone. However, given increasing risks, there are steps you can take now to strengthen your finances.
1) Do not overextend yourself
Economies ultimately overheat as consumers continue to spend more and more. This overspending eventually leads to a crash. In the current environment there is even greater risk of overextending yourself or overpaying for certain items due to supply chain issues and overall demand exceeding supply. One example of this can be seen in the vehicle market, where according to CNBC 82% of consumers are paying above sticker price for a new car.
The risk for overpaying or overextending your finances is greatest on large items like new cars, houses, or renovations. If possible, it is a time for caution and patience.
Also, a common fallacy when inflation increases is a mindset to spend more now given that prices will only continue to rise. This is an inherit part of the psychology and process that ultimately leads economies to overheat and eventually fall. This is acutely happening now.
Reminder: Try not rationalize large expenses with a logic they will only go higher. Instead focus on how much you can afford, review your level of need, and evaluate options to build savings and delay purchases.
2) Build cash balances
Now is a great time to review your cash balances and how much of an emergency fund you desire to hold. Nothing better insulates a household in a recession than having the comfort and confidence of cash.
Below is a link to a previous article discussing a framework for determining how much of an emergency fund you may want to have. A more cautious economic outlook would suggest shifting emergency funds to the high-end of your targeted range.
The good news is that with interest rates rising there are now more competitive rates for cash and cash like investments. One such solution that may make sense for families who want to build extra cash reserves is government I-Bonds. I will be discussing this investment and planning strategy in my next post.
3) Be aware of shifting interest rates for loans
The landscape for different types of consumer loans is also undergoing rapid change. For example, the interest rate on the most common home loan, a 30-year fixed mortgage, has jumped from almost 3% at the start of 2022 to over 5%.
This change will also be beginning to ripple through a variety of other loan types. If you have variable rate loans such as HELOCs, credit cards, or are in need of a new loan, be aware that the math behind financing purchases has likely changed.
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GuidePoint Financial Planning - Reston Financial Planning
Ryan Phillips, CFA, CFP® is the founder of GuidePoint Financial Planning. He is passionate about helping busy families plan, save, and invest for their financial future. Contact him today if you are interested in learning more about the benefits of working with a fee-only (no-commission) financial planner.