No Recession, No Fed Cuts in 2024

Summary

• Recession fears and hopes for deep Federal Funds Rate (FFR) cuts have been rekindled by the recent increase in unemployment.
• This increase is close to the threshold that has historically signaled a recession.
• This time around, the threshold could be providing a false positive signal due to:
  • Data issues.
  • A likely increase in the long-term unemployment rate.
  • Extreme pandemic policy stimulus that could have lowered unemployment to an unsustainable level.

Market Implications

• I expect no FFR cuts in 2024 against markets pricing about four.

Market Pricing Bipolar Macro Outlook

Markets are currently pricing about four cuts by end-2024. This pricing is the average of two polar economic views: 2024 recession and deep rate cuts and continued growth at or above trend and no or few rate cuts (see e.g., Fed will cut interest rates deeply this spring). In this note, I explain why I am in the ‘No cut’ camp, focusing on the recent increase in unemployment.

Sahm’s Rule Is Signalling Imminent Recession

We have heard recession calls many times since the Federal Reserve (Fed) started hiking.  This time around, they are likely to be based on the recent 50bp increase in the unemployment rate to 3.9%, from 3.4% in April.

This time around, the recession calls are more data grounded: small increases in unemployment have sometimes been followed by recessions. This is because of non-linearity in unemployment increases: when unemployment rises above a certain threshold, its increase tends to accelerate and turn into the mass unemployment characteristic of recessions (Chart 1).

In my view, this threshold effect could reflect fixed costs. For instance, rents or debt service for both households and businesses. So, when income starts to fall close to that threshold businesses and households start to cut spending.

And because business spending is household income and household income is demand for businesses products, weaknesses in businesses and household demand are mutually reinforcing. This makes for a fast increase in unemployment, once the economy is over the threshold, much faster than the subsequent decrease once the economy starts recovering.

This threshold effect and the associated bimodal distribution of unemployment rises is the intuition behind Sahm’s rule, developed by the economist Claudia Sahm. The rule predicts that once the 3m average unemployment rate has increased by 50bp from its past 12m trough, the economy is already in recession. It has identified every recession since 1960 without false positives.

The current value of Sahm’s indicator is 33 bp: only two consecutive 10bp increases in the unemployment rate would be needed to bring it to the 50bp threshold. Hence the regained mojo of the recessionistas.

In my view, however, this time is likely different. (Sahm herself thinks the current index value could turnout to be a false positive).

Unemployment Likely to Be Revised Down

First, the increase in unemployment could reflect data issues. The unemployment rate is derived from the household survey, that is noisy: its 90% confidence interval is +/-300,000, compared with the Non-Farm Payroll (NFP) survey +/-130,000. The October unemployment increase was based on a 350,000 contraction in employment that seems implausible in the context of other indicators showing economic strength. For instance, NFP, JOLTS, jobless claims, and surveys such as the NFIB all show a tight labour market.

Employment data tends to get heavily revised, as Governor Waller recently reminded us.  There is a good chance the next NFP prints could show downward unemployment revisions.  In addition, the BLS will publish revisions of the 2019-23 household survey data in January.

U* Has Increased Since the COVID-19 Pandemic

Second, it is likely that the recent increase in unemployment reflects in part an increase in U* the unemployment rate at which there is no slack in the labour market, rather than weaknesses in labour demand.

The post-pandemic increase in U* can be seen through an increase in the ratio of vacancies to unemployment and a decrease in the ratio of actual hires to job openings (Chart 2). Those signal poorer job matching and therefore higher frictional unemployment.

Possible explanations for this loss of labour market efficiency include the mortgage lock in effect: since mortgages are not portable, households that have borrowed long-term on much lower rates than current ones, are locked in their current dwelling. This limits their ability to move to distant jobs. This is consistent with the recent decrease in ‘labour market churning’, i.e., flows between employment, unemployment and not in labour force (i.e., not employed and not looking for a job) relative to the labour force (Chart 3).

While decreasing, labour market churning is still higher than before the pandemic. However, pre-pandemic churning is probably not a good benchmark because of the post-pandemic restructuring of the US economy. Increased churning also happened after the GFC.

Extreme Easing Has Distorted Employment Normalisation

In a typical recovery, labour market normalisation takes place with gradual increases in employment (Chart 4). In the post-pandemic recovery by contrast, the policy response has been so violent that it has brought about extremely large employment increases.

As a result, labour market normalisation has taken place through gradually smaller NFPs.  This suggests that the April low in unemployment could be unsustainable and that the current increase in the unemployment rate reflects labour market normalisation rather than weaker demand for labour.

Both this explanation and the previous one implies a tight labour market, which begs the question of why wages have not increased faster. In my view, this reflects two factors. First, decades of falling union density have slowed the transmission of labor market tightness to higher wages (Chart 5).

Second, even though nominal wage growth is slowing, real wage growth is accelerating. This reflects the decline in energy prices since 2022 and the associated slowdown in headline inflation (Chart 6).

Indeed, one of the unusual — and confusing — features of the pandemic has been the timing of the energy price shock (Chart 7). This time around it took place well after the end of the recession, which has made it difficult to read post-pandemic inflation trends. By contrast, in previous business cycles energy price shocks took place before or during the recession.

Market Consequences

For the reasons discussed above I do not think the recent increase in unemployment signals a recession. I expect unemployment to stabilize or even fall, possibly — and partly — due to data revisions or a combination of strong labour demand and more stable labour supply.

I therefore disagree with the market pricing four 2024 cuts.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)