Recession Reality Check: Are We on the Brink?

In collaboration with Valtteri Ahti, Ph.D. , Chief Investment Strategist and Head of Investment Research at Evli .

The Fed chair Jerome Powell declared that time has come to cut rates at Jackson Hole. The inflation scare has largely abated, only to be dethroned by economic growth scares as the source of market consternation. Are growth fears legitimate and are we headed towards recession?

The Time Has Come

At the Fed’s Jackson Hole summit, Chair Jay Powell announced it’s time to cut rates, signalling the end of a tumultuous era in monetary policy triggered by the pandemic. Before COVID-19, we enjoyed a period known as the Great Moderation, characterized by low inflation, steady growth and low interest rates. However, the pandemic and subsequent expansionary economic policy disrupted this stability, leading to a brief but intense inflationary period.

Powell’s comment indicates that inflation has eased enough, and growth risks have increased, prompting central banks to lower rates. Markets anticipate central banks to cut rate both this year and next year. The pace of these reductions remains uncertain.

Growth Scare

Economic growth concerns have replaced fears of persistently high core inflation. At the heart of these concerns lies the U.S. job market. The job market is clearly slowing, as evidenced by both the unemployment rate and the job creation rate.

Since April 2023, the U.S. unemployment rate has risen from a five-decade low of 3.4% by nearly one percentage point. This increase triggered the Sahm Rule, which states that a sharp rise in unemployment has historically signalled an impending recession.

The Sahm Rule is intuitive: in a recession, firms face declining sales, prompting cost-cutting measures, often through layoffs. As a result, a rapid rise in unemployment generally indicates falling demand, and hence, a recession. The Sahm Rule has only failed to predict a U.S. recession twice —once in the 1950’s and once in the 1960s.

?

Why the Sahm Rule is Misfiring

Sahm herself is on record saying that she thinks her rule has misfired. And it probably has. Firstly, whilst her rule has worked well in the US, it has not worked elsewhere. A rule that works in only one country is more of an exception than a rule.

But the reason Sahm’s rule is misdiagnosing the US economy, is the fact that US layoffs are at a historical low. Less than 1.8 million US workers were permanently laid off in July, which is lower than during the expansionary period prior to the Covid-era recession. It’s difficult to think of the economy being under strain if layoffs are at a historically low level.

Go West, Young Man

Unemployment is rising because of rapid immigration. Immigration in 2022 and 2023 amounted to a total of over seven million people, whilst between 2014 and 2021 immigration averaged less than one million per year. Immigrants tend to be younger than the native labour force and hence the US labour markets has faced a wave of new workers, which it has been unable to absorb.

The immigration wave has been significant both in terms of increasing labour supply and driving economic growth. Immigration on such a scale is rare, and such historical exceptions are precisely the reason why rules of thumb such as Sahm’s rule can misfire.

The US Economy Growing at a Rate of Over Two Percent

Looking at growth itself, the US economy expanded at an annualised rate of 3 percent in Q2. The Fed’s most recent estimate of long run GDP growth is 1.8 percent. Most economists expect growth to slow towards trend growth.

The engine of US growth has been private consumption and investment, with government spending adding a further strength. Out of these three forces consumption seems likely to fade somewhat, because immigration is set to slow and because the household savings rate has fallen to a very low rate of 2.9 percent. The Fed’s rate of monetary easing will be important in supporting the economy as it slows down towards trend growth.

The Trump Card

Kamala Harris has seen her betting odds overtake Donald Trump’s following their first debate. pulled off debate A further twist will be dealt in the US elections in November. In terms of economic growth neither Trump nor Harris seems overtly obsessed with the US deficit and hence government should continue to support the economy. Republican fiscal hawks have all but gone extinct. Hence the impact of elections is more relevant from a burden sharing perspective. Will spending be funded by corporations or individuals, taxes or tariffs.

Expansions Don’t Die of Old Age

The recent history of economic recessions suggests that economic expansions do not die of old age, but due to an exogenous shock. The last three expansions lasted close to seven, ten and eleven years. None ended due to what one might call natural causes. The immediate cause respectively was a dot-com bubble, a financial crisis and a pandemic shock.

But what is exogenous and what is endogenous to an economy? The pandemic was clearly an exogenous event, but the technology bubble and the financial crisis are less clear. One could make the case that the low interest rates of the Great Moderation cultivated these very asset bubbles that ended the longest and second longest economic expansions in US history. Certainly low interest rates caused overinvestment in the housing market prior to the great financial crisis and the corona crisis. Perhaps one cannot have moderation in all macroeconomic domains. Stability in one means flows somewhere else.

For now, it’s hard to make the case for a bubble that makes the economy fragile to shocks. Technology stocks are expensive, but significantly cheaper than during the dot-com bubble. The commercial real estate and regional banking combination is not systemically important enough and seems to be dissipating in any case. Major sectors such as US households, corporations and large banks have strong balance sheets.

The one sector which has a large and growing pile of debt is the US government, but it seems farfetched to think of the US government as the source of future recession. The president of the United States has a lot of say in the matter. Maybe we should spend less time looking at the Fed and more at the White House. The time has come indeed. To elect a new president.