Last man standing

The last man standing for US growth is employment. US growth is starting to show signs of slowing down, from the US housing market to consumer confidence and investment. The final barricade preventing all macro-observers from officially calling a recession in the US is employment. The most recent employment report favoured market bulls. The US economy is continuing to create jobs, and there seems to be no ‘but’ from the job report to jobless claims, so it remains hard to find a solid trace of poor conditions in the US job market, which is probably going to keep the Federal Reserve (Fed) unnerved for some time.

The truth is that two data points cannot determine a macro scenario and the direction of macro data matters just as much as their level. In terms of direction, we have started to see a downtrend in US employment. As 2023 begins, the key question is likely to be whether job deceleration will be the final sign we need to call a recession in 2023. It is a risk to the consensus at least and worthy of investigation.

Not saving private employment

Since the moment the Fed turned its ship away from dovishness to embrace the theory of demand-driven, persistent inflation, its eyes have been on the job market. The well-known Phillips curve relationship paves the way for central bank policy to shape the future of inflation: in order to see a decline in inflation, a higher level of unemployment is needed. By increasing rates through jumbo-sized hikes, the Fed has the explicit intent to create unemployment in order to bring inflation down. The mechanics is simply to push real yields higher by hiking rates and implementing quantitative tightening.

Higher real rates mean many things: they slow the housing market, create negative wealth effects and lead to a decline in private investment as credit becomes scarce and costly. A symptom of this taking affect is a deterioration in the job market; but as this is the ultimate consequence of all monetary policy channels, it usually happens last. The National Bureau of Economic Research’s (NBER) definition of a recession, and dating it, depicts rising unemployment as a necessary condition.

 Figure 1 measures economic activity versus the job market situation, with red dots highlighting the months the NBER has labelled recessionary. Its message is clear: job market deterioration is already happening in the US. ‘Deterioration’ does not mean ‘bad’, and this chart shows that we are clearly not yet in the worst situation. Deterioration means that the direction of the employment market is changing from positive to negative, probably as a consequence of Fed policy. This is step one for lowering inflation and sows the seed for step 2: a bad job market situation. Are we there yet?

Figure 1: Economic activity vs. employment in the US (red dots indicative of recession)

Source: LOIM, Bloomberg.

The Fed’s angelic scenario

To answer that question, we need to understand what the consensus is – both for markets and for the Fed. The striking thing here is that market participants and the Fed agree on the same scenario, which can be broken down into two different elements:

• Inflation should come back to a level close to central banks’ respective targets by the end of 2023, be it in the US or the Eurozone
• Central banks will be able to deliver a soft landing, with negative growth not exceeding -1%

Lower inflation and constraining a recession: the best of both worlds. It took some time for the Fed and the European Central Bank (ECB) to convince investors of that scenario and the more credit we give to it, the likelier it is to happen – the famous self-fulfilling prophecy. Figure 2 illustrates the Fed’s scenario: unemployment should rise next year, without breaching the non-accelerating inflation rate of unemployment (NAIRU) level – the very definition of a soft landing.

Without dismissing that scenario as a base case, we have also added a model of the job market which has a one-month lead over the unemployment rate. This signal is already rising faster than both the market and Fed consensus, but we acknowledge that a decisive turning point cannot yet be confirmed. Our US growth nowcaster, shown below, depicts a similar conclusion: the real deterioration is probably happening quicker than expected. This point is essential as the recent rally feeds from this angelic consensus: should inflation be higher and / or growth be lower than expected then risk-on markets will likely see another round of volatility.

Figure 2. Recent evolution of the US unemployment rate in excess of NAIRU

Source: LOIM, Bloomberg.