Even a slowly cooling labour market often ends with a recession

The job market rarely rebalances painlessly; the Fed hopes this time is different.

The pandemic left the US labour market badly overheated. Reopening businesses panicked at ­labour shortages, paying big raises to hire. As prices shot higher, fears rose of a wage-price spiral.

Recently, though, the labour market has cooled, and indeed looks like something close to normal. Unemployment has crept up from a half-century low of 3.4 per cent a year ago to 4 per cent in May, consistent with what economists consider full employment. The Labour Department releases June data on Friday.

The question now is whether the labour market is in a sustainable equilibrium where unemployment settles at about 4 per cent or keeps softening, resulting in recession – as historically has occurred when unemployment rises much more than it already has.

“This is what the economy looks like when it is at a sustainable simmer, ” said Ernie Tedeschi, a former Biden administration economist now at Yale University’s Budget Lab. “But because we spend very little time in our economic history close to or at full ­employment, there is a lot more uncertainty.”

For the Federal Reserve, which of these scenarios prevails is critical. Inflation fell to 2.6 per cent in May, according to the Fed’s preferred gauge, down from 4 per cent a year earlier but still above its 2 per cent goal. It should fall further as the lagged effect of earlier housing-cost increases diminish, but that is not guaranteed. Fed ­officials say they can take their time to cut interest rates as long as the labour market stays healthy.

On the other hand, there are signs consumer spending has slowed. And if the labour market keeps loosening, it might be hard to stop, which weighs in favour of cutting rates sooner.

“They’re watching a slowdown and at some point, you’re going to want to stop the slowdown from slowing further,” UBS chief US economist Jonathan Pingle said.

Vacancies declining

While it is rare for the labour market to cool without a recession, that is actually what Fed officials said might be possible when they began jacking up interest rates two years ago at the fastest pace in decades to combat high inflation.

Several Fed officials said the ­labour market was so out of balance, companies might respond to higher rates by scrapping unfilled vacancies rather than laying off employees.

So far, that is what has unfolded. In March 2022, when the Fed began raising rates, there were a record two vacancies for every unemployed worker. By April, that had fallen to 1.2, the pre-pandemic rate. This happened almost entirely through falling vacancies rather than rising unemployment. Wage growth and inflation eased at the same time.

The same Fed analysis that predicted this relatively painless inflation slowdown also warned that, at some point, it could turn painful. It said unemployment could begin to move up more significantly once the job vacancy rate fell below 4.5 per cent. In April it was 4.8 per cent, down from 7.4 per cent in March 2022.

“We argued this couldn’t go on forever,” Fed governor Christopher Waller said in January.

Job hiring and quitting rates are back to levels seen 10 and seven years ago, respectively, a sign fewer workers see the opportunity to jump to new, higher-paying jobs. Yet lay-off rates remain low, meaning employers aren’t trying to shed labour.

That makes insured unemployment benefits the best early warning siren for a downturn. Initial claims have ticked up in recent weeks but are still below their year-earlier levels. If claims rise, the case for a rate cut could come together quickly.

A protective approach

Some say concerns about a slowdown are misplaced because much of the uncertainty that ­accompanied rising interest rates has dissipated. Recession fears led employers to pull back on hiring and investing, but recent surveys suggest they are more confident in their future revenues, which could support hiring.

“The labour market is coming out of the storm, and employers are finally able to take a breath and think strategically about the long term,” said Julia Pollak, chief economist at the online-employment marketplace ZipRecruiter. “In 2023, they were in a bit of a protective crouch, very worried about over-hiring ahead of a potential recession.”

That said, economists at Goldman Sachs see hints of weakness. A lower share of new entrants to the workforce are finding jobs. Permanent, as opposed to temporary, lay-offs are on the rise.

Employment staffing companies report their clients are searching less intensively for workers than a year ago. “A job opening … a year ago would have been accompanied by a much more active ­process,” said Julia Coronado, founder of economic-advisory firm MacroPolicy Perspectives.

Mixed messages

The Labour Department’s monthly jobs report is based on two surveys that are now sending conflicting messages. Its survey of payrolls of employers shows payrolls have increased by 2.8 million jobs over the past year, 248,000 jobs a month this year. The second, a survey of households used to calculate the unemployment rate, shows employment up 216,000 over the past year when jobs are defined similarly.

The payroll survey could be overstating job growth, by overcounting jobs created by new businesses and undercounting those lost by closed ones. Pingle says state-level data, including on unemployment benefits, suggests the hiring might be running closer to 200,000 jobs a month over the past year. The household survey might be undercounting employment if it isn’t properly accounting for higher immigration.

The amount of actual hiring is probably somewhere in between the two measures. While that would leave job growth above the historic rate necessary to keep unemployment from rising, that is less encouraging than it seems. Because of increased immigration, monthly job growth of up to 300,000 might be needed to hold the jobless rate steady.

Historically, once the unemployment rate has drifted up by a half-point from its recent low over the past year, it has gone on to rise a lot more, and the economy is in recession. Such a rise is typically concentrated initially in industries such as manufacturing and construction that are especially sensitive to the business cycle and interest rates. But the recent increase was broadbased across industries, according to Goldman, and might reflect over-hiring in 2022 after the pandemic.

“This time really may be different. The unemployment rate may be drifting higher because it is settling into its natural rate,” Tedeschi said. By the same token, “the Fed needs to take seriously that while the labour market isn’t deteriorating quickly, it’s not as ­robust as it might seem on paper”.

The Wall Street Journal