Why a Recession Isn’t in the Cards ... for Now

Ivanna Hampton: Bearish news in the latest jobs report has rattled Wall Street. Unemployment in July rose and triggered a key recession indicator. That information followed the Federal Reserve’s meeting where they held interest rates steady, but they also signaled a potential rate cut in September. Morningstar senior US economist Preston Caldwell thinks the Fed can no longer afford to wait. Thanks for joining me, Preston.

Preston Caldwell: Glad to be here. Hi, Ivanna.

Hampton: Now, recession fears have suddenly swept through the markets. How real is the risk of recession anytime soon?

Caldwell: Well, make no mistake, Friday’s jobs report was a bearish signal, and I do think if the data had been published in time for last week’s Fed meeting, the Fed would have cut at that meeting. But I do think the degree of market reaction that we’ve seen to this one data point is an overreaction. The 10-year Treasury yield has fallen by 40 basis points. The S&P 500 is down 5% cumulatively over the last few days. So, investors are pivoting very hard from risky to safer assets and pricing in a much higher probability of economic weakness and even recession. But all the other economic data that we have is still pointing to a growing economy overall.

GDP growth is still up roughly 3% year over year as of the second quarter. Consumption growth may be decelerating a bit, but it’s still in positive territory. And so I’ll talk more perhaps about the labor market, but I’ll just say usually what we see is economic activity weakened before the labor market, and the labor market responds with a lag. So, the timing of this really doesn’t even make sense that the labor market is already starting to deteriorate because economic activity still looks to be expanding. I’m certainly not panicking. For a while, I have been projecting a slowdown in economic growth but avoiding a recession with growth remaining in positive territory. But after the data we’ve seen, I would say I still expect the US economy very likely to avoid a recession. I really don’t see it being in the cards right now.

Hampton: And a catalyst for all this recession talk was the July jobs report where the unemployment rate jumped and triggered lots of talk about the Sahm rule. Talk about what that is and why it matters.

Caldwell: The unemployment rate was 4.3% in July. It’s averaged 4.1% in the last three months. That’s up about half a percentage point compared to a year ago. And so that triggers the Sahm rule, which says that anytime the unemployment rate in terms of a three-month moving average increases by half a percentage point or more over a one-year period, a recession always follows. And this has held true for every post-World War II US recession on record. It does have a perfect track record, but there are a few points that I would make. And number one, there are so many different data points out there and so many different ways we can slice and dice the data that it’s not surprising that something like the Sahm rule exists. I mean, just by random chance, we would expect many such indicators to exist and have a perfect track record.

So, the statistical significance is not that high. It’s not something we should treat as an iron law of the economy. It’s an indicator that has worked well in the past, but the future is by no means doomed to repeat that past. Secondly, I would say there’s a lot of reason to question the unemployment rate as an indicator right now, the accuracy of that data because, and this is also going to get into the weeds, but it’s important. The BLS, which publishes all the major jobs data for the US, has two major surveys. The household survey and what we call the establishment survey, or the survey of businesses. The household survey shows employment growth, total employment growth up 0.1% year over year. And this is important because the household survey is what’s used to derive the unemployment rate, whereas nonfarm payrolls are up 1.6% year over year.

So, there’s a huge discrepancy between employment growth as measured by the household survey versus nonfarm payrolls. And it’s typically nonfarm payrolls that we as economists put more weight on. That’s why it’s always featured most heavily in the news. If you believe what the nonfarm payroll figures are showing, that conflicts greatly with the picture painted by the unemployment rate. Just within the labor market, we have our two key indicators pointing in very different directions. And it’s true nonfarm payroll growth has been slowing, but it’s still quite solid. And so there’s some reason to question the unemployment data. And so all of that is to say that I don’t think it’s time to panic on the labor market. We should be more cautious, but it’s very premature to be talking about an imminent recession, in my view.

Hampton: There is now this talk of a half-point interest rate cut by the Fed in September. That would be an aggressive first stop. Is that likely? And what do you think the Fed will be doing when it comes to cutting interest rates?

Caldwell: I’ve said previously over the last several months that I do think the Fed will start cutting in September, and that’s become now the market conventional wisdom. And then with this last jobs report on Friday, now the market is expecting a 50-basis-point rate cut in September and even another 50-basis-point cut in either the November or December meeting. So, the market’s now expecting 125 basis points of rate cuts just by the end of this year, which is an astonishing shift from just expecting maybe one or two rate cuts as of several months ago. I do think the market now has gotten a little bit too aggressive. I would say I expect maybe something more like three rate cuts of 25 basis points each or 75 basis points of total rate-cutting by the end of this year. I don’t think the Fed is going to panic in response to this one data point.

Now, if the unemployment rate remains elevated where it’s at or even increases a bit and we also see deterioration in other economic indicators, then yes, absolutely a 50-basis-point rate cut could become our base case in that scenario. But if we see every other part of the economy still looking quite strong, then I don’t think the Fed is going to start off with a 50-basis-point rate cut. We’ll just have to see based on the data, but it’s not a foregone conclusion, which is kind of what the market is pricing in as of this morning with a 90% probability of a 50-basis-point cut in the September meeting.

Hampton: And a quick follow-up: Is there any scenario where you think that the Fed could roll out an emergency rate cut between now and when they meet in September?

Caldwell: There is a scenario. It would not be in response to just the data that we got on Friday, but if we were to see in terms of the economic data, if we were to see an abrupt slowdown in consumer spending or another measure of economic activity, then I do think the Fed could do that. Because the Fed is so close already to achieving its goals on inflation, and it’s clear that if the economy slows down further, then victory over high inflation is a foregone conclusion. It will happen very quickly. It’s just a matter of time. So there’s really no reason for the Fed to keep rates at restrictive levels given those facts. But the Fed also doesn’t want to be seen as panicking unless there really is something that’s screaming emergency in the data. I think we’d have to see another data point in a more adverse direction for the Fed to call an emergency meeting.

Also, keep in mind, just given how much bond yields have already fallen, that already is kind of transmitting expectations of greater Fed easing into the economy because we’ve already seen, for example, mortgage rates fall in response to falling bond yields, and that reaction will continue to play out. And so borrowing rates across the economy are now easing because of the shift in market expectations for monetary policy. And that actually will already start to stimulate the economy a bit and kind of front-load the impact of this monetary easing. That means the Fed doesn’t necessarily have to change the federal-funds rate right now through an emergency meeting in order to start having an accommodative impact on the economy.

Hampton: Well, Preston, thank you for your time today and your insights.

Caldwell: Thanks for having me, Ivanna.