Calling US Peak Employment

“Things are not always what they seem; the first appearance deceives many; the intelligence of a few perceives what has been carefully hidden.”

― Phaedrus

The US jobs market is turning for the worse. 3.9 million Americans currently employed will be out of work over the coming 4 quarters if we look to narrow definitions of employment. When we adjust for labor market participation, the number of unemployed rises by 5.2 million.

The US Payrolls jumped during May, while the household survey provided apparent contradiction. When we look at the figures released in the Employment Situation Report out on June 2, it turns out that Full Time Equivalents actually dropped by a good -892K payrolls if we look at not seasonally adjusted figures. The nominal unadjusted payrolls rose by 920,000 heads. People who have to feed the family and get laid off turn to part time jobs to cover income gaps. In a jobs market which has been unbalanced in favor of job seekers for quite some time, the initial consequences of first wave of peak growth layoffs is a deceptive rise in payrolls as part time jobs are filled. We saw unadjusted hours worked - for all employees on average - fall from 34.6 hours to 34.2 hours, the telltale sign of a full-time to part-time flow of important dimensions under way.

We have seen labor force participation come back to pre-COVID Q4 2019 levels - just entering the long term normal range at the low end in this Q2 2023 at 63.0% and peaking in Q3 2023 at 3.2%. In Q2 2024 we expect participation to have fallen half a percentage point to 62.5%, again drifting outside the long term normal range. US real wages peaked at USD 34.70 in April 2020 and was down to USD 33.37 in May 2023. We project this trend to continue very modestly to USD 33.22 per hour in May 2024. We could speculate that inflation and its consequential reduction of real wages is an incentive for people to come back into the labor force at the margin, simply to pay family bills.

We are calling Q2 2023 Peak Employment as labor force participation adjusted unemployment averages 9.0%, the lowest level since Q4 2019 (8.6% at the same 63.2% participation rate). Over the long term, this broad measure of US unemployment ranges between 5.1% and 11.7%. In Q2 2024 we expect broad unemployment at 11.8%. Narrow unemployment will have risen from a Full Employment 3.4% in the current quarter to the 5.7% long term average rate of unemployment in Q2 2024.

The Fed will expect that this slack in the labor market induced by their commitment to fighting inflation through Fed Funds rate hikes will result in diminished demand pressures and resulting reduction in the pace of price increases for consumer goods in particular. The outlook for market based core PCE-PI inflation is a reduction from 4.5% this quarter to 4.1% a year out - way too modest for the Fed to give up on their price stability mission with a 2.0% inflation target. At this point, our models suggest that the Fed would hike rates to the 6.25% - 6.50% range by Q2 2024. Fighting inflation is a brutal experience in patience, and The Fed will not have either of the components of the Dual Mandate inside the long term normal ranges of values a year from now. As elections 2024 approach, everyone and his dog will join the current choir of Fed critics in calls for a change in policy to accomodate the requirements of an economy that feels recessionary and maybe will be. There are no particular signs in the US national accounts suggesting recession in technical terms is imminent. A slow Q1 2023 was a bump in the road in our models, whereas technical indicators suggest that recession is likely to start in the US in the period Q4 2023 - Q4 2024. Our one-year GDP model forecast would suggest recession would more probably result in 2H 2024. But things are not that simple, and I let the Fed discussion below illustrate.

What will the Fed do?

When it comes to decision making, there is no problem with respect to what people do with perfect information - most would act rationally, make the same decision and be ok with that. When uncertainty about the future is introduced, people differ in their vantage points. As professionals we try to describe these vantage points in scenarios and this added analysis, aided by simulations, offers valuable input to our decision-making. We can keep it sterile and call these options "scenarios", staying in a world of self-imposed ignorance about the future. What some people would argue is that there is an imperative resting upon us: wanting to choose our version of reality. Theory and science, laboratory and simulations will keep us distant from reality choices. If you are bolder, you will translate the scenarios built by your highly valued internal teams into alternative realities for you to choose.

The Fed that is self-declared data dependent, collects data and synthesises these in future scenarios within their Dual Mandate of maximum employment and price stability. They also have a financial stability mandate and may temporarily give priority to this, as any financial instability may destroy the fabric of economic activity. We saw that at 9-11-01, the 2008 subprime crisis, the 2020 pandemic, and the banking sector turbulence earlier this year. The Dual Mandate cannot be ringfenced without financial stability, so the latter will always take priority and handled as an emergency situation in a National Security perspective.

When the Fed formulates policy based on data, it will need to look at the range of indicators related to employment and prices. The favored indicator of price stability is the PCE-PI - but which version is best for policy-making? Should rates be set on the base of headline or core inflation? Should the market-based indices be used? These choices result in very different positions on the outlook for inflation, for policy emphasis (between Dual Mandate components), and for policy direction.

If the Fed chooses to remain focused on PCE-PI market based core inflation, the Fed Funds rate should be hiked by 50 bps this month to the 5.50% - 5.75% range. Policy response to rising unemployment will not materialize, as inflation strength will dominate in the decision models. As Jamie Dimon of JP Morgan warned last week, there is a good chance the Fed will rise rates towards 6 - 7% over the coming year. We have the market based core focused Fed raising the policy rate to 6.50% - 6.75% at the end of 2024. The policy direction remains 100% focused on prices, and this prevails even in the face of a recession.

If, instead, the Fed chooses the reality faced by all Americans - reflected in the headline PCE price index - the policy dynamics change. The Fed hikes by a quarter point this month, and again to the 5.50 - 5.75% range in Q3 2023. In Q4 2023, employment becomes the dominant Mandate and the Fed cuts 200bps that quarter to a 3.50% - 3.75% policy rate range. The only change is that the FOMC decides that its preferred reality for policy direction and rate decsions is reflected in the PCE-PI headline number. The rest is pure model math. The implications is also that the model response coincides with a normalization of the UST yield curve, as the cost of overnight money falls sharply. In this scenario, we see the Fed raising rates by a quarter in Q1 and in Q3 2024, ending the year at 4% Fed funds.

You can run models all day long and get any answer you want that fits your world view. The masters of policy must leave the models out of the room and debate among themselves (and with their constituents in the Districts) which reality they should adopt as their guide for monetary policy. We would argue that the Dual Mandate is best reflected in the headline inflation gauge, which is what also measures the total range of Personal Consumption Expenditures in the US. Our analysis has brought us to view a US recession as likely to start in the Q4 2023 - Q4 2024 time frame. The market based core inflation measure is not supporting that reality version, while the headline PCE-PI forecast does, triggering the policy response to above-average unemployment.

Summary

US heading for recession starting Q4 2023 following a substantial rise in unemployment, triggered by rising cost of credit and resulting capital rationing.

The Fed to hike in June 2023 and once in Q3 2023, both 25 bps hikes. Peak Fed Funds at 5.50% - 5.75%.

Fed will monitor data and likely cut twice by 100 bps in Q4 2023 as unemployment accelerates and quarter-over-quarter Real GDP proxies fall.

US 10-year yield continues to rise to average 3.86% in Q4 2023 and to 4.28% on average in Q2 2024. Yield curve normalizes as the short end collapses, remaining moderately upward sloping through 2024.

PCE-PI inflation falling from 3.88% in Q2 2023 to 3.09% on average in Q2 2024, and so coming within the long term normal range of PCE-PI inflation (0.78% - 3.33%).

WTI crude oil to fall to USD 46/bbl, just above the USD 45 long term average price of crude.

Bonds look like a poor investment through Q2 2024, although keep an eye on real rates.

Corporate earnings to continue falling. Equities look like a poor investment through Q2 2024. The market is looking over the horizon and should begin discounting recession now. Did you sell in May?

So much for a "strong Employment Situation report".