Do Prices Drop During a Recession?

A recession is a significant downturn in economic activity lasting more than a few months. It is characterized by a broad decline in indicators like real gross domestic product (GDP), income, employment, industrial production, and sales. While two consecutive quarters of negative GDP growth is a common indicator, economic organizations consider a broader set of data to declare a recession. This period marks a contraction phase in the business cycle, where the economy slows down.

Understanding Price Movements in a Recession

During a recession, prices tend to experience disinflation or, in some cases, deflation. Disinflation is a slowing in the rate of price increases, meaning prices are still rising but at a more gradual pace. Deflation, conversely, is an actual decrease in the general price level across an economy, where prices generally decline. This occurs when the inflation rate falls below zero.

Reduced consumer demand and an economic slowdown are the primary forces driving these price behaviors. As economic activity contracts, people spend less, decreasing demand for goods and services. This diminished demand often results in businesses cutting prices to encourage sales and clear unsold inventory. Overall price levels reflect this reduction in spending and business activity.

However, not all prices adjust uniformly or quickly. “Sticky prices” describes how some prices resist downward adjustments, remaining relatively constant or adjusting slowly despite changes in supply and demand. Businesses might be reluctant to lower prices due to concerns about signaling weakness, damaging their brand image, or incurring “menu costs” associated with changing price lists.

This phenomenon is observed in sectors where firms produce less rather than significantly cut prices. While some prices, particularly for flexible goods like gasoline, adjust quickly, others, especially in the service sector, tend to be stickier.

Key Drivers of Price Changes

Prices during a recession are influenced by demand-side and supply-side factors. On the demand side, a primary driver is decreased consumer spending. As unemployment rises and job security becomes uncertain, households have reduced disposable income and become more cautious with expenditures, especially for non-essential items. This lowers overall demand for goods and services, compelling businesses to consider price reductions.

Businesses adjust inventory levels in response to falling demand. With fewer sales, companies accumulate unsold goods, creating an incentive to offer discounts or lower prices to manage stock and cash flow. Reduced business investment is another demand-side factor, as firms hesitate to expand or invest during uncertain times, further dampening demand. This cycle of reduced spending and investment puts downward pressure on prices.

Supply-side factors also play a role, though their impact varies. Reduced demand for raw materials can lead to lower production costs, enabling businesses to lower prices. However, supply chain disruptions, which can accompany downturns, can prevent prices from falling or even lead to increases. If key inputs become scarce or expensive, businesses face higher costs, counteracting downward price pressure from reduced demand.

Central bank monetary policy and government fiscal policy influence economic conditions and prices. Monetary policy, managed by central banks, involves adjusting interest rates and the money supply. During a recession, the Federal Reserve might lower interest rates to make borrowing cheaper for consumers and businesses, aiming to stimulate spending and investment and support price levels. This seeks to increase aggregate demand and prevent a severe price downturn.

Fiscal policy involves changes in government spending and taxation. To combat a recession, the government might implement expansionary fiscal policies, such as increasing spending on infrastructure or providing tax cuts. These measures aim to boost aggregate demand, increase disposable income, and encourage economic activity, which can help stabilize prices or mitigate downward pressure. Both monetary and fiscal policies foster a return to more stable price conditions.

Divergent Price Trends Across Goods and Services

Price movements during a recession are not uniform across all economic sectors, showing divergence between various goods and services. The distinction between essential and discretionary items is noticeable. Essential goods, like basic food and utilities, tend to have less flexible prices. Demand for these items remains stable, as consumers purchase them out of necessity, even with reduced incomes. Their prices may not decline significantly, or might even rise if supply-side pressures exist.

In contrast, discretionary goods and services, which are non-essential purchases like luxury items or entertainment, typically experience substantial price drops. As consumer spending tightens during a recession, these categories are often the first cut from household budgets. The sharp decline in demand pressures businesses to lower prices, offer discounts, or reduce production to avoid unsold inventory. This makes such items more likely to see price reductions.

Service prices tend to respond differently than tangible goods, generally exhibiting more stickiness, meaning they are slower to adjust downwards. This is often due to the significant labor component in service delivery, as wages are a sticky price. Employers are reluctant to cut wages due to concerns about employee morale and productivity. Since wages are a substantial portion of service providers’ costs, their inflexibility contributes to the stickiness of service prices.

Housing rents and wages are prominent examples of sticky prices. Rental agreements are often based on contracts that do not immediately reflect economic changes, leading to a lag in price adjustments. Wages are typically slow to decrease, even during high unemployment. This stickiness in wages can prevent businesses from significantly lowering costs, limiting their ability to reduce prices for goods and services, especially those with high labor input.