Rate rises and the contraction of the Fed’s balance sheet may still pull the rug from under the economy and markets. There are times when one wants to be wrong. I have felt this way several times in the past 15 months, whether in warning last year that inflation would not prove transitory or cautioning that the Federal Reserve was rapidly falling way behind on its inflation objective and running out of first-best (“soft landing”) policy options.
Today, my discomfort relates to the view that the recent jobs report implies that the US will now avoid a recession, a view that several analysts have embraced and which is reflected in prices for stocks and corporate bonds. While I very much hope this view is correct, I believe it is too early to declare the recession watch over, something that the government bond market seems more attuned to.
Don’t get me wrong, the report was very strong. Jobs increased by 528,000, twice the consensus forecast and bringing US employment above its pre-pandemic level. At 3.5 per cent, the unemployment rate is at pre-pandemic lows, and wages are now growing at 5.2 per cent, again above consensus. The one disappointment is a labour participation rate that continues to slip lower.
The data confirm that, even though the technical definition of recession was triggered by the 0.9 per cent second-quarter GDP decline, the economy is not in a recession using the more holistic concept favoured by the vast majority of economists. But this does not mean that the risk of a recession within the next 12 months has been eliminated. Nor does it guarantee that a recession, were it to occur, would be shallow and short.
Forward indicators suggest that the current strength of the labour market should not be taken for granted. This is not just about the inconsistencies between the two surveys that constitute the monthly report (establishment and household).
Away from that, job openings are declining at an historically rapid rate, weekly jobless claims are increasing and several companies have signalled their intention to slow hiring and/or lay off workers. Meanwhile, the beneficial effects of the just-passed Inflation Reduction Act by the Biden administration, while consequential over the long term, will do little to immediately alter this.
Then there is the policy angle. Going into the release of the report, most economists had dismissed as puzzling the comment by Fed chair Jay Powell on July 27 that policy rates were already at neutral (the level consistent with neither an expansionary nor a contractionary monetary policy).
The report confirmed what other data and analytical signals had suggested: the central bank still has a lot of work to do to get rates to neutral and beyond, now that it has allowed inflation to get entrenched into the system.
While headline inflation is expected to fall in the next three months (the July reading is due out on Wednesday), core measures are likely to stay uncomfortably high and prove unpleasantly sticky. As the Fed scrambles to regain control of inflation and restore its damaged credibility, aggressive rate hikes and the contraction of a bloated $9tn balance sheet risk pulling the rug from under the economy and markets. These have been conditioned for way too long to function with floored rates and massive liquidity injections.
The alternative of an early pause in the hiking cycle is not a good one as it risks leaving the US with both inflation and growth problems well into 2023.
The government bond market understands this, as shown by the current inversion of the yield curve with short-term rates rising above longer-term ones. Investors are unusually willing to accept lower compensation for allocating their money to a longer maturity investment. This is a traditional signal of a rapidly slowing economy, and the inversion intensified to some 40 basis points following the release of the jobs report.
All this is not reflected in stock prices and corporate bond spreads, which remain well supported by all the liquidity still sloshing around the system and an investor mindset set at exploiting relative rather than absolute valuation. Indeed, the dominant narrative in markets is that company profits will largely bypass lower sales growth, higher wage costs and another leg-up in some other costs.
I sure hope the growth optimists are right. Already hampered by slow Chinese growth and the threat of a European recession, the last thing the global economy needs is the twin shock of a US recession and a bigger Fed policy mistake. Indeed, I am looking for reasons to embrace their views. Unfortunately, and to my great regret, my analysis of what is ahead is inconsistent with doing so.
Mohamed El-Erian is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy