Unexpected labor market report dims economic outlook: Recession fears increase

An unexpectedly weak U.S. jobs report, showing the highest unemployment rate since the pandemic, has reignited fears of an impending recession. Such a development could dash the Federal Reserve's (Fed) hopes for a soft landing of the economy. The stock markets are reacting with significant price fluctuations due to the suspicion that the Fed has kept interest rates too high for too long. A months-old narrative of a Goldilocks scenario (less inflation, steady growth) was suddenly displaced by gloomier expectations. But what is the actual state of the U.S. economy? Although it is rare for a single metric to provide a complete picture, it is worthwhile to consider several indicators. Some still point to ongoing growth without a recession, while others are less optimistic. In the second quarter, the gross domestic product (GDP) rose by an annualized 2.8%, corresponding to the average of the last six quarters and roughly matching pre-pandemic growth. An indicator monitored by Fed Chair Jerome Powell—final sales to private domestic purchasers—also remained stable in the second quarter at 2.6%. Another positive aspect is the service sector. The Institute for Supply Management (ISM) service activity index returned to expansion territory, with both orders and employment numbers rising. A rival index from S&P Global showed the highest activity in over two years in July. Interest rates remain high because inflation rose sharply in 2021 and 2022 and fell more slowly than expected. However, current data shows that inflation is approaching the Fed's target of 2%, which could enable rate cuts soon. Investors are wondering whether the Fed waited too long to shift its focus from inflation to the labor market. The labor market raises concerns: U.S. employers have slowed down their hiring, from an average of 267,000 new jobs per month in the first quarter of 2024 to only 114,000 in July. The unemployment rate rose to 4.3% in July, the highest rate since October 2021. According to the Sahm rule, such an increase in the unemployment rate tends to signal an economic downturn. Claudia Sahm, who defined this rule, recently said the economy is likely not yet in a recession but "we are uncomfortably close." An increase in the household debt rate amplifies concerns. According to the New York Fed, the rate rose to 3.2% in the first quarter. Younger and lower-income credit card holders have been particularly affected, with default rates increasing significantly. Economic reports have mostly disappointed economists' expectations in recent months. Citigroup’s Purchasing Managers Index, which measures such surprises, clearly shows that confidence in the Fed's ability to deliver a soft landing has diminished. Should a recession indeed occur, the handling would look different this time. The Fed currently has more leeway to cut interest rates than during the pandemic. However, high public debt could restrict fiscal stimulus measures.