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It is too early to declare risk of US recession is over

The writer is president of Queens’ College, Cambridge, and advisor to Allianz and Gramercy

There are times when one wants to be wrong. I’ve felt this way several times over the past 15 months, whether I warned last year that inflation would not be transient or warned that the Federal Reserve was quickly falling way behind its inflation target and running out of first-best ( “soft landing”) policy options.

Today, my discomfort is related to the view that the recent jobs report implies that the US will now avoid a recession, a view that several analysts have embraced and that is reflected in stock and corporate bond prices. While I very much hope this view is correct, I think it’s too early to announce the recession watch, something the government bond market seems to be more geared towards.

Don’t get me wrong, the report was very strong. The number of jobs rose by 528,000, twice the consensus forecast, pushing US employment above pre-pandemic levels. At 3.5 percent, the unemployment rate is at its lowest pre-pandemic level, and wages are now growing at 5.2 percent, again above consensus. The only disappointment is an ever-decreasing labor participation rate.

The data confirms that while the technical definition of recession was driven by the 0.9 percent decline in GDP in the second quarter, the economy is not in recession according to the more holistic concept favored by the vast majority of economists. . But this does not mean that the risk of a recession in the next 12 months has been eliminated. Nor does it guarantee that a recession, if it did occur, would be superficial and brief.

Future indicators suggest that the current strength of the labor market should not be taken for granted. It’s not just about the inconsistencies between the two surveys that make up the monthly report (establishment and household).

Aside from that, job openings are declining at an all-time high, weekly unemployment claims are on the rise and several companies have signaled their intention to delay hiring and/or firing workers. Meanwhile, the beneficial effects of the Biden administration’s just passed Inflation Reduction Act, while having long-term implications, will do little to change this immediately.

Then there is the policy corner. When the report was released, most economists had dismissed Fed Chair Jay Powell’s July 27 comment that key rates were already neutral (the level corresponding to neither an expansionary nor a contracting monetary policy) as puzzling.

The report confirmed what other data and analytical signals had suggested: The central bank still has a lot of work to do to get rates neutral and higher, now that it has anchored inflation into the system.

While headline inflation is expected to decline over the next three months (July reading due on Wednesday), core measures are likely to remain uncomfortably high and prove uncomfortably sticky. As the Fed works to bring inflation under control and restore damaged credibility, aggressive rate hikes and the contraction of a $9 trillion bloated balance sheet threaten to pull the rug from under the economy and markets. These have been conditioned for far too long to function with floor rates and massive liquidity injections.

The alternative of an early pause in the walking cycle is not a good one, as it threatens to leave the US with both inflation and growth problems well into 2023.

The government bond market understands this, as evidenced by the current yield curve inversion with short-term rates rising above longer-term rates. Investors are extremely willing to accept a lower fee for allocating their money to an investment with a longer maturity. This is a traditional signal of a rapidly slowing economy, and the inversion increased to about 40 basis points after the release of the jobs report.

None of this is reflected in stock prices and corporate bond spreads, which stay well supported by all the liquidity still sloshing around the system and an investor mentality aimed at exploiting relative rather than absolute valuation. Indeed, the dominant story in markets is that corporate profits will largely evade lower revenue growth, higher labor costs and a fresh rise in some other costs.

I really hope the growth optimists are right. The global economy is already hampered by slow Chinese growth and the threat of a European recession, but the last thing the global economy needs is the double shock of a US recession and a bigger policy mistake by the Fed. Indeed, I am looking for reasons to embrace their views. Unfortunately, and much to my great regret, my analysis of what lies ahead is inconsistent.

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