A Strong Jobs Market May Not Be Good News For The Economy

Within a few days of news breaking that US GDP had contracted for a second consecutive quarter in 2022 (which in many countries defines a 'technical recession') the US labour department published a report on August 5th showing that the economy added 528,000 new jobs in July - double the amount economists had predicted. Unemployment in the US is now 3.5%, its lowest level in fifty years.

In Ireland, according to the Central Statistics Office (CSO), unemployment now stands at 4.2% meaning the Irish economy has made a full recovery since the pandemic. There are now as many people in employment in Ireland as in 2019.

And yet, the talk of recession rambles on. How do we make sense of this contradictory data?
 
As July’s job figures in the US were not factored into Q1 and Q2 of GDP, it’s possible that the economy may have shrunk between January and June of this year but then rebounded shortly after. This will be very welcomed news to President Biden but less so to Jerome Powell, the chairmen of the Federal Reserve, America’s central bank, in light of soaring inflation.
 
As of August 10th, US CPI is 8.5% on a year-on-year basis when compared to July of last year. This is lower than June's figure of 9.1% compared to June 2021. Inflation, therefore, seems to be headed in the right direction thanks mainly to falling oil prices. Further price pressures on energy may yet occur, however, as China exits lockdown and Russia weaponises its gas supplies in Europe this winter. Some analysts are predicting inflation could hit 11% or 12% over the coming months. 
 
Bear in mind the extraordinary measures by the Fed in 1981 when inflation hit 14%. Paul Volcker, the then Fed chair, increased interest rates to an astonishing 18% and purposely engineered a deep recession. Unemployment rose to 11% the following year and inflation fell to 3.2%. With labour markets tightening and inflation still well above target, today’s central banks may be forced to act with similar resolve. 
 
While interest rates are rising many economists believe they are still too low given the level of inflation. Currently the Fed funds rate is 2.5%, arguably far below the ‘neutral’ rate (neither stimulative or contractionary) as recently suggested by Jerome Powell. Such analysis will do little to improve waning confidence and credibility at the Fed since inflation is over three times higher than nominal interest rates. The real interest rate in the US when adjusted for inflation is -6%.
 
In Europe, the main deposit rate at the ECB is 0% despite a 50 basis points increase in July from -0.5%. Adjusted for inflation, the real rate of interest in the Eurozone is -8.6%. Central banks, therefore, have lots of ground to make up to get inflation under control. The longer they wait the bigger the risk of inflation becoming entrenched and even more tightening needed at a later date.
 
At present, wages are not rising as fast as inflation so in real terms incomes are falling. This should, in theory, have a dampening effect on demand in the short term and inflation may fall. The Bank of England, however, is taking no chances. Andrew Bailey, the BOE’s governor, published on Aug 5th a very gloomy outlook for the UK economy projecting four quarters of negative GDP growth between 2023 and 2024. Given its concern about inflation, which it thinks could hit 14%, the BOE is determined to continue raising rates and live with the consequences.
 
In the US as jobs growth continues, the path towards a 'soft landing' is ironically becoming much narrower. As prices increase and demand for workers continues, higher wages feed into higher costs which firms pass on to consumers. The result is even higher inflation.
 
In normal times, central banks target an inflation rate of 2% by adjusting interest rates and to a lesser extent controlling the money supply. Through careful manipulation of its monetary levers, the central bank achieves a ‘goldilocks’ zone where the economy is neither too hot nor too cold. This anchors the public’s expectations of inflation at relatively low levels. Wage-price spirals are thus a rare occurrence.
 
But given the exogenous supply shocks from the pandemic followed by a demand shock when the economy rebounded, the inflation genie is now well and truly out of the bottle. Keeping a lid on 8% or 9% inflation when the economy is still growing becomes extremely challenging. Added to that is the central banks’ inability to directly control food and energy prices. Central banks can influence demand but not supply. With inflation nearing double digits, interest rates are the central banks main policy tool to reduce demand and bring down inflation. As rates rise, households, firms and governments face higher debt servicing. Along with reduced purchasing power from higher prices, demand is expected to significantly fall. This ‘demand destruction’ is precisely what the markets are now pricing in over the next few years.
 
Consider the inversion of the 10 year yield curve below in July 2022. An inversion occurs when yields at the longer end of the yield curve fall below the short end reflecting where investors believe future interest rates will go. During the lifespan of a bond, if rates rise the value of the bond falls. Investors therefore buy bonds at an interest rate they believe protects their future returns. Buying long bonds at a rate lower or close to short term rates is a sign that the market believes the economy is headed for a recession and a period of much lower inflation. Inverted yield curves have preceded each recession since 1955.​

To minimise the risk of recession central banks may decide to slowly adjust rates upwards by another 1% or 2%, after which point they may stop, analyse, then go again. Probing the economy looking for weak points, however, is a tight balancing act, especially given global debt levels. The hope from the Fed's or the ECB's perspective is that these lower rates manage to dampen inflation expectations in the short term and buy themselves more time before inflation moves higher. By then perhaps supply chains will have improved and the conflict in Russia has come to an end. But these are big assumptions to make.
 
Even if inflation peaks this year and falls considerably below current levels, history shows that when inflation is above 4% and unemployment is below 5% recessions often occur either way. Eventually the economy becomes too uncompetitive and firms cut costs. It seems, regardless of their policy choices, the central banks are stuck between a rock and a hard place. 

​With the value of its exports as a percentage of its GDP at 135%, Ireland will hardly be immune from adverse conditions facing the global economy. Europe’s woes including the possibility of another debt crisis are also a major concern; not to mention escalating tensions between China, the US and Taiwan. Our economic fate over the next number of years, therefore, may be out of our hands.​