Has the US Federal Reserve gone too far in its fight against inflation, tipping the world’s largest economy into a damaging recession?
This troubling question has shaken global markets out of a long period of calm. Expect more turbulence before an answer emerges.
Two weeks ago, I switched allegiance from hawk to dove, dropping my support for higher interest rates and arguing for immediate cuts to avert a recession. Not a moment too soon, it turns out. Since then, evidence of a weakening labor market and moderating inflation has accumulated rapidly, strongly suggesting that the Fed is behind the curve.
Most notably, the three-month average unemployment rate reached 4.13%, up 53 basis points from its lowest level of the prior 12 months. This breaches the 50-basis-point threshold that, as recognized by the Sahm rule, has always indicated a US recession and much higher joblessness to come.
Beyond that, payroll growth has slowed along with hiring and quit rates, while initial and continuing jobless claims have risen. On the inflation front, the Fed’s preferred measure — the core deflator for personal consumption expenditures — registered its third consecutive benign monthly reading in June, up just 0.2% from May. Average hourly earnings were up 3.6% in July from a year earlier, compared with 3.8% in June, consistent with the slowing trend in the second-quarter Employment Cost Index.
Many economists — including Claudia Sahm herself — argue that the Sahm rule doesn’t necessarily apply this time: Strong labor force growth, rather than firing, has driven the rise in the unemployment rate. “A statistical regularity is what I’d call it,” said Fed Chair Jerome Powell, when asked about the rule. “It’s not like an economic rule where it’s telling you something might happen.”
They might be right, but I wouldn’t base monetary policy on that assumption. The Sahm rule worked just fine in the late 1960s and 1970s, when the labor force was also growing quickly. It reflects a fundamental economic process: A deteriorating labor market tends to be self-reinforcing. Unemployed people and those worried about their job security spend less, which leads businesses to cut back further on hiring. When the Sahm threshold has been breached, unemployment has always gone much higher. The smallest trough-to-peak rise was nearly 2 percentage points.
What, then, should the Fed do? The longer it waits, the greater the potential for damage: Monetary policy is tight and becoming tighter as price and wage inflation moderate. It needs to get to neutral. Federal Open Market Committee members’ estimates of the neutral interest rate range between 2.4% and 3.8% (I’d put myself in the top half of that range). This means there’s a long way to go from the current effective fed funds rate of 5.3%. And if a recession materializes, the Fed will need to go into accommodative territory — to 3% or less.
An immediate rate cut is in order, but that’s very unlikely. It wouldn’t be consistent with Chair Powell’s deliberative manner, and the Fed rarely makes such moves outside of its regular policy-making meetings — only when a severe shock changes the economic outlook dramatically or threatens financial stability.
That brings us to the next policy-making meeting on September 17th and 18th. The Fed could cut by either 25 or 50 basis points, depending on what the economic data show between now and then. After that, the path is unclear. It could be a gradual series of 25-basis-point cuts ending below 4%, or a steeper descent into stimulus if the Sahm rule holds.
Uncertainty about the trajectory of monetary policy will probably remain high for many months. So prepare for more volatility in stock and bond markets.
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