The US economy has yet to face the greatest challenge of recession

A person removes the nozzle from the pump at a gas station on July 29, 2022 in Arlington, VA.

Olivier Douliery | AFP | Getty Images

It would be hard to find a recession in the rearview mirror right now. However, what comes next is a different story.

There is no historical precedent that would indicate that an economy in a recession could create 528,000 jobs in a month as the United States did in July. The unemployment rate of 3.5%, compared to the lowest since 1969, is not consistent with the decline.

But that doesn’t mean there is no recession ahead and, ironically, it is the phenomenal resilience of the labor market that could pose the greatest long-term threat to the economy as a whole. The Federal Reserve is trying to ease the pressure on historically tense employment conditions and rapid wage growth by trying to control inflation at its highest level in more than 40 years.

“The fact is that this gives the Fed additional room to tighten further, even if it increases the likelihood of pushing the economy into recession,” said Jim Baird, director of investments at Plante Moran Financial Advisors. “Continuing tightening without negative repercussions for consumers and the economy will not be an easy task.”

Indeed, after solid job numbers that included a 5.2% 12-month increase in average hourly earnings, traders stepped up betting on the more aggressive Fed. On Friday afternoon, markets attributed a roughly 69% chance the central bank would make a third consecutive 0.75pps interest rate hike when it met again in September, according to CME Group data.

So, while President Joe Biden celebrated the number of big jobs on Friday, there could be a much more nasty data point next week. The consumer price index, the most widely observed inflation index, emerges on Wednesday and is expected to show continued upward pressure even as gasoline prices drop sharply in July.

This will complicate the central bank’s equilibrium of using rate hikes to moderate inflation without plunging the economy into a recession. As Rick Rieder, director of global income investments at asset management giant BlackRock, said, the challenge is “how to soft-land” when the economy gets hot and lands on a runway he has never used before. “.

“Today’s print, which is much stronger than expected, complicates the work of the Federal Reserve to create a more moderate employment environment in line with attempts to contain the current level of inflation,” Rieder wrote in a customer note. “The question is, however, how long (and higher) will it take before inflation is brought under control?”

More signs of recession

Financial markets have bet on the Fed in other ways.

The yield on 2-year government bonds exceeded the yield on 10-year bonds with the highest margin in about 22 years on Friday afternoon. Known as the inverted yield curve, this phenomenon is a telltale sign of a recession, especially when it continues over an extended period of time. In this case, the inversion is valid from the beginning of July.

But that doesn’t mean a recession is imminent, just that it is likely to happen within the next year or two. While this means that the central bank has some time on its side, it could also mean that it will not have the luxury of slow hikes, but rather it will have to continue to act quickly – a situation that policymakers hoped to avoid.

“This is certainly not my primary case, but I think we can start hearing some rumors of a hike between meetings, but only if the next batch of inflation reports is hot,” said Liz Ann Sonders, Charles’s chief investment strategist. Schwab.

Sonders called the current situation an “exceptional cycle” in which demand shifts back to services from goods and poses many challenges to the economy, making the debate about whether the US is in recession less important than that what’s ahead.

This is a widely shared view of economists who fear that the most difficult part of the journey is still ahead of us.

“While economic output contracted for two consecutive quarters in the first half of 2022, the strong labor market means we are probably not in a recession right now,” said Frank Steemers, senior economist at The Conference Board. “However, economic activity is expected to cool further towards the end of the year and the US economy is increasingly likely to fall into recession by the end of the year or early 2023.”

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