The recent surge in the U.S. unemployment rate has unsettled financial markets, sparking new concerns about a potential recession. Despite these worries, the situation may not be as dire as it seems.
The latest jobs report, released last Friday, indicated a slowdown in hiring, coinciding with other signs of an economic cooling. High prices and increased interest rates have added to these concerns. A survey of manufacturing firms revealed a significant weakening in activity during July. Additionally, Hurricane Beryl’s impact on Texas, which occurred during the same week the government compiles its job data, might have contributed to the restrained job growth.
Traditionally, the U.S. economy has offered clear signals when it was approaching or entering a recession. However, since the onset of the COVID-19 pandemic, these indicators have become less reliable. Over the past few years, warning signs of economic downturns have surfaced repeatedly, only for the economy to continue expanding.
As the presidential election approaches, discussions about a recession have become increasingly politicized. Former President Donald Trump’s campaign criticized the latest jobs report, describing it as “more evidence that the Biden-Harris economy is failing Americans.” On the other hand, President Joe Biden emphasized the strength of the job market since he and Vice President Kamala Harris took office, highlighting the addition of nearly 16 million jobs and the drop in the unemployment rate to historic lows. While some of these gains are a rebound from the pandemic, the U.S. now has 6.4 million more jobs than before the crisis.
Nonetheless, the Labor Department’s report has rekindled recession fears. The Dow Jones Industrial Average plummeted over 600 points, or 1.5%, on Friday, with the broader S&P 500 dropping almost 2%. Market anxiety was fueled partly by the rise in unemployment to 4.3% last month, the highest since October 2021, which triggered the Sahm Rule.
The Sahm Rule, named after former Federal Reserve economist Claudia Sahm, suggests that a recession is almost certainly underway if the three-month average unemployment rate increases by half a percentage point from its lowest point over the past year. This rule has accurately signaled every U.S. recession since 1970. However, Sahm herself is skeptical about an imminent recession. Speaking before the latest data was released, she remarked, “If the Sahm Rule were to trigger, it would join the ever-growing group of indicators, rules of thumb, that weren’t up to the task.”
Several other previously reliable recession indicators have also failed to hold true in the post-pandemic period, including:
– The “inverted yield curve,” a bond market measure that typically signals a recession.
– The rule that two consecutive quarters of declining economic output constitute a “technical recession.”
Federal Reserve Chair Jerome Powell acknowledged the Sahm Rule and its implications during a news conference last Wednesday but noted that other recession signals, such as changes in bond yields, have not been reliable in recent years. “This pandemic era has been one in which so many apparent rules have been flouted,” Powell stated. “Many pieces of received wisdom just haven’t worked, and it’s because the situation really is unusual or unique.”
Powell made these comments after the Federal Reserve chose to keep its key interest rate unchanged but hinted at a potential rate reduction at its next meeting in September. He downplayed the significance of the Sahm Rule, describing it as a “statistical regularity” rather than a definitive economic law. “It’s not like an economic rule where it’s telling you something must happen,” he explained.
Economists have struggled for four years to interpret an economy that was initially shut down by the COVID-19 pandemic, only to rebound with such vigor that it reignited inflationary pressures dormant for four decades. When the Federal Reserve began raising interest rates aggressively in March 2022 to curb inflation, most economists predicted that the resulting higher borrowing costs would trigger a recession. However, this recession has yet to materialize.
Post-pandemic shifts in the U.S. labor market may have temporarily diminished the accuracy of the Sahm Rule. The steady rise in unemployment is not primarily due to widespread job cuts but rather because a large number of people have entered the job market, with many unable to find employment immediately. A significant portion of these new job seekers are immigrants, including those who entered the country illegally. They are less likely to participate in Labor Department job surveys, leading to an undercount of employed individuals.
The inverted yield curve is another indicator traditionally associated with recessions. This phenomenon occurs when the interest rate on shorter-term Treasury bonds, such as two-year notes, exceeds the rate on longer-term bonds like the 10-year Treasury. This inversion has been ongoing since July 2022, the longest such period on record, and typically suggests that the Federal Reserve will need to cut rates to stave off a recession. Historically, the inverted yield curve has predicted each of the last ten U.S. recessions, often with a lead time of one to two years, though there was a false signal in 1967.
However, this time, the yield curve’s prediction has yet to materialize. David Kelly, chief global strategist at J.P. Morgan Asset Management, notes that the curve usually inverts because long-term yields fall in anticipation of a rate cut by the Fed during a recession. But currently, investors expect rate cuts not due to an impending recession but because inflation is declining. “The perception of why the Federal Reserve might cut short rates right now is quite different from the past, and that’s why the yield curve is not nearly as ominous as it has been in previous episodes,” Kelly explained.
Tiffany Wilding, an economist and managing director at bond giant PIMCO, attributes the muted impact of the Fed’s rate hikes to the government’s massive financial assistance packages in 2020 and 2021, totaling around $5 trillion. These funds bolstered consumers and businesses, allowing them to spend and invest without relying as heavily on borrowing, thereby dulling the recessionary signal from the inverted yield curve.
In 2022, the government reported that gross domestic product (GDP) had declined for two consecutive quarters, a classic recession indicator. Then-House Speaker Kevin McCarthy declared that the U.S. was in a recession, but he was later proven wrong. While headline GDP figures showed a decline, a closer look revealed that underlying economic activity, excluding volatile factors like inventories and government spending, continued to grow at a robust pace.
Despite the rise in unemployment last month, which some economists fear could signal a broader economic slowdown, consumer spending, especially among higher-income households, remains strong. As long as layoffs stay low, consumer spending is expected to continue.
“It doesn’t seem to me like the U.S. economy has fallen out of bed,” said Blerina Uruci, chief U.S. economist at T. Rowe Price’s fixed income division. “I’m still not in the camp that the U.S. economy is headed for a hard landing.”