Another false signal for the US economy

The rise in the unemployment rate in last Friday’s US payroll report puts it at its highest point since January 2022 at 3.9% 

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Determining whether recessions are likely is not easy, unless there’s a huge adverse shock like the COVID-19 pandemic. Judging when they might start is tricker still. There is one indicator, the rise in the unemployment rate, which is close to suggesting that recession is not just likely, but imminent. But should we trust such signals?

After all, another supposedly reliable indicator, yield curve inversion has been flashing warning signs for well over a year now, if we take the 10s-2s curve, and yet no downturn has materialised. Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said the Standard Bank’s view on many of these indicators of recession is that they are interesting, but not necessarily reliable. As former BIS head William White puts it, an economy is a not some sort of static machine such that, when you put something in, you always get the same thing coming out. Instead, it is a complex adaptive mechanism, ever changing, so that things that might have happened in the past, such as yield curve inversion signalling a recession, might not be repeated in the future.

In the case of curve inversion, there’s also a very accessible reason why the signal of recession has been false so far, and could be in the future. It relates to quantitative easing and the way that this has held longer-term rates down; something that seemingly creates quite a bias to the yield curve if we consider a curve starting from the fed funds target rate or short-term cash rates out to the long end of the bond market.

But what about the labour market? Survey that’s a reliable indicator of recession? There are a number of labour market indicators that are thought to be useful recession predictors. One such indicator is Sahm’s rule, named after a former Fed economist Claudia Sahm. It suggests that recession is imminent when the moving average of the unemployment rate rises by 0.5% points above the low seen for the unemployment rate in the prior year. It’s supposedly a fool proof indicator not just for predicting recession but signalling that one is about to start.

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The rise in the unemployment rate in last Friday’s payroll report puts it at its highest point since January 2022 at 3.9% and half a percentage point above the low of 3.4% seen in January of this year. The Sahm indicator currently stands at 0.33; so not too far from the 0.5 level that would suggest recession is about to start. But, like the seemingly misguided curve inversion rule, is the Sahm rule vulnerable to the vagaries of the labour market right now?

For instance, the labour market does have some very unique features at the moment. The first is the most obvious one, which is the very low level of unemployment with even 3.9% still below the Fed’s best estimate of the full employment level. And then there’s the huge surge in vacancies that we’ve seen in the wake of pandemic; something that is only being whittled away very slowly. For instance, the JOLTS measure of job openings shows that, while vacancies have fallen 20% from their peak in March 2022, they are still 33% higher than pre-pandemic levels.

“We could go on but, in our view, if we have learned anything in recent years it is that the US economy has not behaved in a way that many would have expected, either in terms of the rise and stubbornness of inflation, or the robustness of the economy in the face of such sharp rate hikes. To think that a rigid rule, like Sahm’s rule is going to prove accurate against such a fluid backdrop is probably misguided. This being said we would not argue that a recession is definitely going to be avoided, or even unlikely. But we would caution that rules like curve inversion and Sahm’s rule do seem to be there to be broken. The first seems to have let us down and the second may well go the same way”, said Mr. Steve Barrow.