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Economic Insights

A look at the key takeaway from September’s U.S. jobs report—and its implications for the U.S. Federal Reserve.

While much of the focus on September’s U.S. employment report from the U.S. Bureau of Labor Statistics was on the lower-than-expected growth in private nonfarm payrolls on the month (114,000 versus economists’ median expectation of 130,000, as compiled by Bloomberg), or the modest slowing in the growth of average hourly earnings (2.9%), other components of the September data suggested a far different story. The drop in the unemployment rate from 3.7% in August to 3.5% in September implies that the U.S. economy was growing far above potential (counter to the recession narrative on offer from many economic forecasters and financial media outlets) and that there is no hint of an impending recession. Employment as measured by the household survey has been booming for many months due, in part, to a sharp decline in underemployment; the broad U-6 unemployment rate dropped to 6.9% in August.

The newly popular Sahm indicator of recession1 shows that the unemployment rate has risen by 0.5% (three-month moving average vs. lowest rate in the prior twelve months) or more before a recession started in every post-WWII downturn. Obviously, with the unemployment rate falling to a new cyclical low in September, there is no hint that the process of a weakening labor market leading to recession has even begun.

 

Chart 1. The Sahm Indicator Suggests that a U.S. Recession Is Not in the Cards
Data for the period April 30, 1949–September 30, 2019

Source: Bloomberg.  The Sahm indicator compares the current U.S. unemployment rate to its low point over the previous 12 months. (Both are measured using a three-month average.) When that gap hits 0.3%, the model suggests that risks of a recession are elevated; at 0.5%, the downturn has probably already begun.

 

According to these indicators, the household survey data actually implies that U.S. gross domestic product (GDP) is growing faster than potential (otherwise the unemployment rate wouldn’t be falling), and that there is no hint of a slowdown. This creates a problem for U.S. Federal Reserve (Fed) policymakers since it is widely believed that an unemployment rate in the low 3-percent range would put the economy in a steeper region of the Phillips curve2 that would lead to a sharper acceleration in inflation. If the downside risks it has identified fail to materialize, the U.S. economy could enter a period of cyclically accelerating inflation that could quickly exceed the Fed’s 2% target, and even rise above the modest overshoot policymakers appear willing to tolerate.

Fed Policy Implications
The September employment data present the Fed’s policy-setting arm, the Federal Open Market Committee (FOMC), with a difficult decision with respect to future rate cuts. If the downside risks that threaten future growth materialize, the 50 basis points (bps) of cuts on the fed funds target already made (25 bps each in July and September 2019), and even more, will prove justified. But if the economy continues to grow at around 2%, or accelerates, the pace of inflation could pick up much more quickly than expected as the unemployment rate falls to 3%, or even below.

While we believe the FOMC would welcome inflation rising to its 2% target, or even to as much as 2.5%, forecasts could easily be revised higher for late-2020/2021 if the unemployment rate falls to as low as 3%. At that point, negative real (inflation-adjusted) short-term rates would imply excessive monetary accommodation and the Fed would have to reverse course.

All things equal, we believe the Fed would prefer to engineer a gentler path of rate cuts and future rate increases than a steeper one. The September employment report, on balance, likely supports FOMC members that argue a pause at the next meeting (October 28–29) is appropriate following two consecutive rate cuts. Indeed, any language in the Fed’s October statement addressing prospects for reacceleration in economic growth—and strengthening inflation—could significantly dampen market expectations for future easing.   

 

1The so-called Sahm indicator was developed by U.S. Federal Reserve economist Claudia Sahm. It compares the current unemployment rate to its low point over the previous 12 months. (Both are measured using a three-month average.) When that gap hits 0.3%, the model suggests that risks of a recession are elevated; at 0.5%, the downturn has probably already begun.

2The Phillips curve, an economic concept developed by A. W. Phillips, holds that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment and vice versa.

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