The relative weakness in July’s nonfarm payroll employment number and the increase in the rate of unemployment from 4.1% in June to 4.3% in July, triggering the Sahm Rule is a reminder of the difficult tasks ahead for the Federal Reserve (Fed). We are going to give Fed officials the ‘benefit of the doubt’ in that it did not have advanced notice of the employment numbers we were going to get two days after the decision to keep interest rates unchanged in July.
Again, even if the Sahm Rule has been triggered, we agree with the author of the Sahm Rule, that this time is different. And it is different not only for the Sahm Rule but also for a plethora of other economic indicators, starting with the yield curve, which has been inverted for more than two years, to the Leading Economic Indicator, which had been pointing to a recession for more than two years, to the ISM, manufacturing as well as services, which have been pointing to economic weakness, to household employment, which has been signaling weakness for a long time compared to the still relatively strong nonfarm employment numbers, etc.
It is clear that the pandemic recession messed up every economic indicator that economists used to use to get a feel for economic activity. And, the normalization process for these indicators will continue to take time just because the pandemic completely destroyed typical trends and patterns we used to hold true. We do not blame those who are in charge of the calculations and data processing, both federal, state, and local officials as well as those private organizations that provide timely indicators because they are doing the best they can. However, this increases the importance of interpreting data and looking at more non-traditional data, as Larry Adam, Raymond James CIO indicated clearly during the RJ Summer Development Conference in Orlando in mid-July.
It is also important to remind everybody that although the nonfarm payroll number in July was much lower than expected, 114,000 jobs created is still a relatively strong number for the US economy which, on average, creates about 125,000 per month.
Is the Federal Reserve Behind the Curve... Again?
This is the question almost everybody, including the markets, is asking: after being accused of being behind the curve as inflation started to accelerate as the economy reopened from the postpandemic recession, something that we believe was unjustified and fundamentally out of its hands, the Fed now faces the prospects of being accused of being behind the curve as real interest rates continue to bite and could, potentially, send the US economy into a recession.
If this is the case and the US economy falls into a recession, this time around, it is all on the Fed!
We say this because the surge in inflation was not something the Fed could have done anything about it. As we have said so many times before, the pandemic economic cycle was a fiscal cycle, not a monetary cycle. The Fed could have hiked interest rates to, say, 5.25% immediately in the middle of the pandemic recession, but the fiscal expansion was so large that it wouldn’t have made any difference with inflation, as other countries that didn’t have the same fiscal expansion we had experienced similar inflationary pressures.
It, thus, started to increase interest rates to buy time to be in a good position once all the excess cash transferred to individuals and businesses by the federal government had been flushed out of the economy while at the same time, we waited for the disruptions to worldwide supply chains to normalize.
But the Fed knew that all those funds were almost entirely depleted during the first quarter of the year and Americans were only relying on ‘good-old-disposable-income’ to keep the economy going. But there were strong signs that this lifeline was also slowing down, so it was correct in pricing in three 25 basis points cuts for the federal funds rate before the end of the year.
Then the Fed got an inflation scare, a scare that should not have changed its view on the inflationary path and rate cuts. Many firms increased prices considerably during the first quarter of the year, something that seems to have been unexpected and probably further affected the treatment of seasonal factors. We will not know this for sure for several years, but this is what we believe happened.
This made the Fed overreact and change its view on the forward path for inflation, thus changing its view on the need to cut rates during this year. Now, this overreaction is threatening to put the Fed really against the ropes and behind the curve. Hopefully, if we are correct, this is just a downshift in economic activity and we can avoid a recession, which is what we have in our forecast today. However, the August employment number, which is slated to be released before the Fed meets next time, will be the most important number to watch. If the August employment number is very weak, close to 100,000 or below, then it raises the probability of the Fed moving by 50bps in September. But before that, Fed officials are going to meet in Jackson Hole on August 22-24 for their Economic Policy Symposium, which has a very timely title: “Reassessing the Effectiveness and Transmission of Monetary Policy.” We really hope they reassess their ‘overreaction function’ from earlierin the year.
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