Is the Fed behind the curve, and could that set the stage for a U .S.
recession ahead? If there is a recession in the next year or so, it is a huge, unforced policy error, right?
And I'm much more concerned about that now than I have been in the past.
I'm Alison Nathan, and this is Goldman Sachs Exchanges.
Every month, I speak with investors, policymakers, and academics about the most pressing market -moving issues for our top of my report from Goldman Sachs Research.
This month, I'm taking a closer look at Fed policy and the U .S.
economic outlook. The most recent jobs report was much weaker than expected.
In fact, it triggered the SOM rule, which states that when the unemployment rate's three -month average rises half a percentage point or more above the last 12 months low, the U .S.
is already in a recession.
If that's the case, as it has been in every U .S.
recession since 1970, or if a recession materializes down the road, some pretty sharp questions will be asked about Fed policy.
At Jackson Hole, Fed Chair Powell clearly signaled that the Fed was set to cut interest rates at its upcoming September meeting.
But the Fed fund's rate remains quite high, and with inflation readings having come down significantly, some economists are wondering why the Fed hasn't started cutting already.
Our economists in Goldman Sachs Research believe that the Fed will cut its benchmark rate by 25 basis points in September, November, and December.
Compared to most, they're relatively unconcerned about recession risk, putting 20 percent odds on a U .S.
recession in the next 12 months, which they say would decline to 15 percent, the default risk of recession at any point in time, if the August payrolls report due this week is benign.
They note that while the July jobs report was weak, other data are not showing signs of recession.
To find out more, I spoke to three of the foremost experts on the U .S.
economy and Fed policy.
Bill Dudley and Rob Kaplan are both former Federal Reserve presidents.
Bill served as president of the New York Fed and vice chairman of the FOMC after spending a decade here at Goldman Sachs as our chief U .S.
economist. Rob is the former president of the Dallas Fed and current vice chairman of Goldman Sachs.
But first up is Claudia Somme, the chief economist at New Century Advisors.
She was previously an economist at the Federal Reserve, where she created the recession indicator that now bears her name.
I start by asking her for some background on the Somme Rule.
So I developed this recession indicator, the so -called Somme Rule, in early 2019.
And it was part of a policy project on how to improve fiscal stimulus.
We needed an indicator to turn on temporarily programs in a recession.
And what I did to construct the indicator was look at the historical record of recessions in the United States and the changes in the unemployment rate that happened with a particular eye to an indicator that was both highly reliable, because it was going to start off a big fiscal program, and triggered
as early as possible in a recession.
But it was looking at historical patterns.
I did use the data as they were published at the time, the real -time data.
So to try to get away from, well, after the fact, we see all these revisions.
And going from 1970 on, it had, this was by construction, I was trying to make it reliable.
It had a perfect record, would have at the time.
And then before 1970, there are a few false positives in the real -time data, but recessions followed soon thereafter.
But there were some close calls, and it's not, you know, things like the threshold to half a percentage point increase over the prior year on a three -month average basis that was selected because of the historical record.
There's nothing intrinsic about a half a percentage point or the particulars of the formula per se.
And we recently saw the indicator get triggered.
So tell us about that.
The unemployment rate moved up 0 .53 percentage points.
So that would trigger the SOM rule.
And so then historically, that is consistent with U .S.
economy being in the early months of a recession.
If we look at the broader context in which it triggered, the U .S.
economy is in all likelihood, not in a recession.
Income is growing, consumer spending is growing, jobs growing.
This is not an economy that's in contraction.
But that's what the SOM rule says.
It's supposed to only turn on in a recession.
It is not a forecast of a recession.
It is supposed to be an indicator.
So it's something that should move pretty slow and only turn on inside of a recession.
So if it turns on outside of a recession, it may still be telling us something useful.
And yet it, like, that's not what it was supposed to do.
So is the rise in the unemployment rate that everyone's so focused on maybe giving us a misleadingly negative picture of the U .S.
economy? So the reason the SOM rule works is typically increasing the unemployment rate, particularly when they get of a certain magnitude or driven by less demand for workers.
And that, whether that's in layoffs or not getting hired or, you know, in various ways you get less demand for workers, then that can feed on itself because those workers spend less.
And then there's less demand for other workers.
And so that is the feedback loop that leads into a recession.
That is the recessionary dynamic that these small changes in unemployment rate or bad news picks up on, right?
Now, there are other reasons that the unemployment rate can go up that are good reasons, at least long -term good reasons.
And that would be, if you have an increase in unemployment rate because you've had this burst in supply of workers, more workers, well, then as the jobs catch up, if the economy otherwise isn't a good place, the jobs catch up, those workers get jobs.
And then, in fact, you have more growth coming out of that because you have more workers.
So it has a positive prognosis once you get those workers employed, whereas the negative reasons that unemployment goes up tend to spiral into recession.
And this was something, you know, when I developed this on roll in 2019 and talked about this, this was always the Achilles heel of using an unemployment rate measure.
There are times where, you know, labor force participation changes and that can move around the unemployment rate.
What's notable right now is these have been very big and abrupt changes.
And so that adjustment period to, oh, we have more workers online, you know, the jobs catch up, like that process just can't happen fast enough when you have, you know, million plus extra unexpected workers, say, from immigration, though it's not the only group coming off the sidelines, that supply
shock moved so fast and was big enough that it overwhelmed.
But the song will, while it is overstating the degree of that weakening of demand for workers, some of that is there, right?
It overstated that it moved past to have a percentage point threshold.
But part of that came from this supply piece, which is not the recession story.
But it's not all good news, right?
It's a real mixed bag.
It's a complicated story.
So let's dig through that mixed bag a little bit.
We have seen hiring rates and quit rates declining as well.
So does that give you greater cause for concern when looking at the holistic data?
So absolutely. Right.
And, you know, anytime you as an economist start in the this time is different.
Like I have this indicator, it's worked for decades and decades and decades.
And now, oh, it's it's not working.
You have to be really careful.
The way in which employers express their demand for workers, they have lots of different levers to pull and firing, laying off workers is actually even just in a typical recession, one of the later leverage you pull, right?
Like a recession towards the end does have a big contribution from layoffs to the unemployment rate.
But again, the summer was focused on this early side of it.
So they're just in general, you shouldn't think, oh, well, there hasn't been layoffs.
So everything's fine with the labor market.
That's not the case in recessions as you go into them.
But then you have this extra piece of, well, there does appear to be some kind of an attitude change, at least anecdotally among employers of having laid off millions of workers by the week early in the pandemic and then having so much difficulty rehiring that there has been a reluctance to lay off
workers. And so then that, Martin, if you have less demand for workers, you lean harder.
Employers are leaning harder on the hiring rates.
And right now there's a pretty notable disconnect between hiring rates that are back to levels of 2014 when the unemployment rate was well above where we are right now and the firing rates, which are at very low levels.
So you don't have to be a little careful because this time could be different on many margins, which make it hard for us to read the data and the declines in the hiring rate.
And also the quits rate, which I think are a very good indicator of how strong workers assess the labor market to be.
Those are a way of saying, no, there really is some weakening of demand for workers in here.
So, you know, all this is building to the million dollar question, which is how concerned are you that the U .S.
economy is going to enter recession in the next 12 months?
So I'm always concerned about bad things that happen.
Macroeconomists. No, so I feel very confident in saying, yes, it triggered in July of 2024.
No, the U .S. economy is not in a recession, but that is a really low bar in terms of good macroeconomic outcomes.
What I am concerned about, what I have been watching for, and I am really concerned about the direction, payroll gains are still solid, but they keep slowing.
That unemployment rate is still low, particularly if you think about some of these temporary, like the supply price, but it is rising.
So it's that direction, but the reason that my base case is not a recession is the understanding that at least a portion of the slowing that we're experiencing right now is a policy choice.
The Federal Reserve has their federal funds rate over 5 percent, it's been over 5 percent for a year now, and the reason it is high is it was an attempt to bring inflation down.
It's like, what do we expect?
Yes, unemployment is rising gradually.
There's been a lot of buffering.
We haven't had the recession, we haven't had the pain that some thought we would or needed to even have, but it is still there, right?
But if you're putting downward pressure on the U .S.
economy through somewhat higher interest rates, I mean, there's a release valve there and the fact that that's a lever to pull and the Fed is in a position to pull it, I think they could have already, but they are moving there.
So that makes me more confident that things are still of a good place, but I don't like the direction of my recession odds, though they fluctuate some, are higher now than they've been through the whole cycle.
Do you think the Fed is behind the curve, though, given everything you've seen?
The framing of the behind the curve, I have a hard time with, because at this point, it really doesn't matter.
They can't go back and cut in July or not, but the path is clear in terms of their cutting.
We're at a point where things are slowing down and they don't need to, like the inflation, we are very close to target.
So at this point, if there is a recession in the next year or so, it is a huge, unforced policy error.
If the Fed pushes down on the economy, continues to, and we end up in a recession, well, then it was completely unnecessary.
And I'm much more concerned about that now than I have been in the past.
One of the things that the Fed had often messaged in various forms throughout the year, they want more good inflation data, more good inflation data, and essentially that they have the luxury of time because the labor market is so strong.
And that always struck me as a very risky proposition to like use the labor market as your kind of security blanket.
And now we're to a place where anything that looks like that is just beyond risky behavior.
The Fed needs to move.
I am not of a, they are so far behind the curve.
We need to see 50s.
We need to see 75s.
And yet if the Fed doesn't move, they just ratchet up the risks and for no good reason.
At this point, inflation is so low and the labor market has enough question marks around it.
The worst possible outcome is a recession we didn't need.
It's a slow moving institution.
It's a very little C conservative institution and the leadership kind of selects for that trade.
And it's often a good thing.
Like you want people that are deliberate and thoughtful, but they waited quite a while.
And so I worry. If the August employment report comes in much stronger than expected this week, will that change your views?
A strong report would probably slow the Fed down that I'd worry more.
Really? You know, if the report is too good, I think it gives a false sense of confidence potentially because you don't want to react to one month too much and things swing around.
But again, unless you really can make a case that the direction of travel has leveled out until that happens.
And I don't know how that happens when you still have the interest rates intentionally high to restrain demand, right?
So I'm not really not going to rest easy until things have leveled out and the Fed funds rate is notably lower than where it is now, or we have made a really good case for the fundamentals have shifted in a way that the economy just tolerates and needs to stay in balance, a higher interest rate.
So Claudia says that despite what her namesake rule might suggest, the U .S.
is not currently in a recession.
However, she does see some disconcerting signals from the labor market and she cautions that the Fed must act decisively to avoid further weakening in the labor market that could lead to a recession.
Next, I spoke to former New York Fed president Bill Dudley.
Claudia is not Sanguin, but Bill is actually even more worried.
He thinks the recession is more likely than not at this point.
I asked what he made of the SOM rule getting triggered.
Look, the SOM rule, it's not magical.
It's a statistical regularity.
And the threshold was set at whatever level was necessary to generate accuracy in terms of its recession predictions in the past.
That doesn't mean that that threshold necessarily mechanically applies in the present.
But when the unemployment rate goes up a bit, historically, it tends to not stop.
And I think the corollary of the SOM rule that I think is important is not just the trigger, but the fact that when the unemployment rate goes up beyond a certain point, the next stop is a appreciable rise in the unemployment rate.
So if you look at history, it's going up a half a percent on a three -month movie average basis.
And then the next stop is 1 .9 percentage points.
So that hole in the distribution is telling you that this is not just about statistic.
There's a process going on.
If the labor market deteriorates beyond a certain point, it starts to scare households and businesses, households pull back on their spending, businesses pull back on their hiring and investment.
That leads to additional economic weakness, which causes this feedback move to be self -reinforcing.
So when I talk about the SOM rule, I spend as much time talking about this hole in the distribution, which suggests that there is some sort of tipping point in the labor market.
Now, whether we've hit it just because we triggered the SOM threshold, I don't know at this point.
I think the odds of recession are lower than what you would just mechanically say.
I probably put it at 50 to 60 % over the next 12 months.
The other thing that I also put a little bit more weight on, I mean, some people, is going into recession, typically, the data look better than what they ultimately turn out to have been.
So the government releases the GDP numbers, they release the employment data based on underlying assumptions of, for example, employment data, like what's the creation of new businesses versus businesses that are failing.
They just have to make an estimate of that.
And in economic turning points, what typically happens is it turns out those assumptions turn out to be too optimistic.
Sometimes these differences are quite significant.
So the data that we think we're offering of today, that data could be revised downward.
Right. So we could be in a lot worse of a situation than we think we are right now.
It's certainly possible.
Certainly possible.
But yeah, rather than saying, oh, we're going to have a recession, we're not going to have a recession, the good way I would put it is the risks have risen.
And because the risks have risen and the Federal Reserve needs to put more weight on the employment side of their mandate, that means the Fed needs to get from a tight monetary policy regime back to a neutral monetary policy regime more quickly rather than more slowly.
So just as the Fed was behind the curve in terms of raising interest rates in the cycle, I think the Federal Reserve is a bit behind the curve now in reducing interest rates in response to these increased risks.
I think in soft landing, it's certainly possible and certainly what the Chair Powell is going for, cutting interest rates now would increase the probability of the soft landing.
But here's where there's a problem.
If they lag the monetary policy or long -term variable on the way up, they're also long -term variable on the way down.
And so historically, at least, it's been very hard for the Federal Reserve to intervene soon enough when there's economic weakness to prevent a full -fledged economic downturn.
If you look at history, the only time the Fed has really had a soft landing in the last four years or so is the mid -1990s.
And what was interesting about that mid -1990s period was the Fed didn't actually push the supply rate up at all.
And the supply rate basically stabilized.
So there was never much risk of this negative self -reinforcing dynamic taking hold during that soft landing.
And what the Feds try to do now is replicate that mid -1990s experience.
That's what they're going for.
And we'll see whether they could pull it off or not.
And so just to review, again, the odds that you put a recession...
Probably 50%, 60 % over the next 12 months.
I mean, I think it's higher than normal, but I'm not going to take the sound rules and say, well, just because it's been triggered, then that means we absolutely have to have a recession.
I do have to say that I always feel a little uneasy when people say, well, this time is different because we've seen many examples.
I mean, the great financial crisis is the best example.
But going into that, everyone said this time is different for US housing.
This time is different for mortgage underwriting.
And it turned out not to be different at all.
But those episodes seem to be driven by big imbalance in the economy.
I mean, that's not what you're saying here.
Or are there imbalances in the economy that are contributing to your thinking?
Well, I think there aren't big imbalances.
I personally feel like financial markets should be relatively well underpinned, because to your point about imbalances, I don't think there's a risk of a deep recession.
I think if there's a recession, it's going to be a very mild recession because the household and business balance sheets are in generally pretty good shape because of the large fiscal transfers that we saw during the pandemic.
And the Fed has plenty of room to cut.
We're at 5 .25 to 5 .5 % on the set of hundreds, so there's plenty of room to cut.
And with inflation not that far away from the Fed's 2 % objective, there's the ability to cut if the economy shows weakness.
So I think worst case scenario is a mild recession.
Finally, I spoke to Rob Kaplan, former president of the Dallas Fed and now vice chairman here at Goldman Sachs.
He also acknowledges a softening in the economy but seems less concerned than his former central bank colleague.
We started by talking about the Fed's dual mandate to foster price stability and maximum sustainable employment.
The inflation battle isn't over.
And because the cumulative level of inflation is so high, it's very important that we continue the inflation battle because middle -class families, low -moderate income, can't make ends meet.
But we're seeing some softening overall in jobs, and we're seeing enough improvement on inflation that I can view them both as more balanced.
And from a risk management point of view, our next move, I think in September, it's time that we start reducing the Fed funds rate.
As you know, the July employment report came in much weaker than expected and set off a lot of market volatility as a result.
That was just days after the Fed had decided to keep rates on hold.
When you're sitting at the FOMC and you're thinking about upcoming data, how does that factor into your decisions?
My caution to everyone is, and you'll hear this from Fed people, if I'm sitting at the Fed, first don't overreact to one data point.
It could be misleading, it could be distorted, could get revised, and that it's very possible that the August jobs report is going to turn out to look like a more normal jobs report, and this is going to turn out to be an aberration.
So that's the first thing.
The second thing, if you're at the Fed, is talk to contacts, make sure you're talking to contacts, i .e.
businesses out there, and see if this jobs report jibes with what you're hearing.
I think it does not.
The job market is softening, which we wanted at the Fed, but I don't think it's falling out of bed.
So be careful not to overreact even rhetorically to it, and don't be surprised if August is not much more solid.
If I'm wrong, you've got all your options open at the Fed to do more in September than 25 basis points.
But you don't think the Fed is behind the curve here?
If they're behind, they're not behind by more than a meeting or two.
That I would view as tactical.
The mistake by the Fed that I'm more nervous about is a strategic mistake.
So what's an example?
In 21 and 22, I thought the Fed was 18 to 20 months late.
That's a strategic error.
If you're a meeting or two late, you can probably fix it with doing a little bit more in some meetings.
That's a tactical error, and I would differentiate between the two.
But I would caution.
If I were at the Fed, I'd be prepared to cut, and I would talk hawkish.
So why would I do that?
Because I want to keep my options open.
Once I say, and sound dovish, I've lost all my options.
So I would say don't overreact to hawkish rhetoric.
I think those same people that sound a little hawkish are prepared likely to cut in September and maybe November and December.
But they're going to sound a little hawkish, as I would too, because I want to have the option to make the decision.
So what would be your advice to investors who are attempting to navigate the evolution of Fed policy and the economy ahead?
I call data the bouncing ball.
It comes out several times a week, PCE, CPI, PPI, GDP.
If you want to be a data hound, there's unlimited amounts of data.
Economists like it because you can put it into a model.
However, it tends to be backward -looking, it's stale, it's aggregated, and normally gets revised.
So you have a big reaction to it that a month later you find out it's been revised already.
I think you're much better off focusing on demographics, aging population, technology -enabled disruption, the energy transition, regulatory policy, and other structural factors.
And I think you got to look at the data, but don't be maniacally narrowly focused on data.
It's interesting because in that last point, Rob does sound similar to both Bill Dudley and to Claudia Somme.
All the economists, including the one who gave her name to a data -based rule, caution that the numbers just don't paint the whole picture, which might be why economists' opinions vary so dramatically.
Let's leave it there.
Thank you for listening to this episode of Goldman Sachs Exchanges.
I'm Alison Nathan. The interviews with Bill Dudley, Claudia Somme, and Rob Kaplan were recorded on August 14th, and August 19th, respectively.
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