Those waiting for a pick-up in unemployment to signal a looming recession or that the Fed can finally declare victory may be too late.
Those citing a tight labor market as a reason that we could avoid recession or that the Federal Reserve (Fed) has more work to do should be reminded that the unemployment rate tends to be a deeply lagging indicator, as does inflation, and therefore may not yet fully reflect the impact of interest rate hikes over the past year.
If we look at the last 12 U.S. recessions:
- On average, the unemployment rate bottoms just 8 months before we enter recession. If January 2023 remains the bottom in the unemployment rate, the economy could be on track for recession later this year.
- It takes an average of 14 months for the unemployment rate to peak after the economy enters recession.
- In 9 of the last 12 recessions, the unemployment rate peaked after the economy exited recession. In the remaining 3, the unemployment rate peaked during the final month of recession.
Despite a structural labor shortage, the labor market is unlikely to entirely avoid a cyclical rise in unemployment and we could see negative payroll growth by the end of the year.
In addition, inflation tends to be a lagging indicator, although less so than unemployment. Peak consumer price index (CPI) tends to precede the peak unemployment rate by about one year on average over the last 11 recessions, and its descent tends to be much swifter. Inflation tends to peak within 3 months of recession, often reflecting an overheating economy. This time, peak inflation in June 2022 reflected a spike in commodity prices, enduring supply chain issues, and robust consumer spending.
Combining these two indicators, the so-called “misery index”– the unemployment rate plus the annual inflation rate—underscores these lags:
- It takes an average of 9 months for “misery” to peak after the economy enters recession.
- “Misery” has peaked after a recession has started in all of the last 11 recessions.
Those waiting for a pick-up in unemployment to signal a looming recession or that the Fed can finally declare victory may be too late. Although the Fed insists on being data dependent, incoming data does not necessarily reflect the full impact of monetary policy. If this aggressive rate hiking cycle, which is expected to continue in the next Federal Open Market Committee (FOMC) meeting, pushes the U.S. economy into recession, investors would be wise to take advantage of elevated bond yields today to lock in higher income and build portfolio protection for a more challenging economic climate ahead.