Sports lovers around the world are being treated to the spectacle of the Summer Olympics in Paris. Every four years our attention is rapt, as we cheer on our respective nation’s athletes in international competition.
Men’s and women’s gymnastics are clear fan favorites. And whether on the parallel bars, the beam, the high bar, or the pommel horse, fans of gymnastics collectively hold their breath for the dismount. That’s when the athlete, having completed his or her routine, spins, tumbles, and twirls to a landing on the mat, hoping to ‘stick’ the dismount.
Monetary policy, like gymnastics, is a performance of twists and turns. The degree of difficulty depends on various factors, including the macroeconomy, other policy settings, the global economic environment, and the health of the financial system. Nevertheless, the aim, as in gymnastics, is to achieve a soft landing, the perfect monetary policy dismount.
Until this past week, it looked as if the Federal Reserve was going to stick it. Following a challenging routine of tightening steps to bring down soaring inflation of 2022-2023, the Fed was poised to land the economy softly, guiding inflation to its 2.0% target without inducing a recession or a rise in unemployment.
And until this past week, the audience was enthusiastically cheering the Fed’s routine. This was evident in soaring global equity markets, tight credit spreads, and a general feeling that stocks, bonds, and other assets would deliver even stronger returns once the Fed began to cut interest rates.
Alas, it seems the Fed may have misjudged the degree of difficulty of its routine. It had, perhaps, become cocky, certain that it could balance the competing needs of reducing inflation and maintaining maximum employment.
This past week, various economic indicators, including the Institute for Supply Management (ISM) manufacturing survey, jobless claims, and almost all aspects of the July employment report indicated that the US economy is faltering, and may be headed for recession. Rather than stick the soft landing, the Fed now appears to have waited too long to dismount from its tight monetary policy. If so, the landing could be awkward and painful, for the Fed as well as for investors and ordinary Americans.
The financial markets, ever fickle, have turned cheers into catcalls. Bond yields, stock prices, and many commodity prices (e.g., crude oil) tumbled this past week, a sign that investors now anticipate a much harder landing for the economy and corporate profits.
Evaluating and forecasting something as complex as the US economy should never be reduced to a single variable. Yet many pundits are now homing in on the so-called ‘Sahm Rule’ (named after former Fed economist Claudia Sahm), which notes that a 0.5 percentage point rise in the three-month moving average of the unemployment rate always precedes a US recession. That ‘rule’ has now been triggered, with the US unemployment rate rising from its 2024 low of 3.4% to 4.3%
But other indicators are also worrisome. In July, the ISM manufacturing index slumped even further below the expansion/contraction line of 50, indicating that output in the goods-producing sectors of the economy is shrinking even more than previously thought. And although the rate of employment growth last month (114,000 new non-farm jobs created) is broadly consistent with the rate of growth of the US labor force, the July gains were well below both expectations and the rate of average monthly job creation since 2021. Moreover, nearly half of July’s payroll increase was in healthcare services, meaning that job formation in more cyclical sectors has nearly flat-lined.
Those looking for good news in the numbers will point to a rising participation rate, meaning that more Americans are returning to the labor market. Perhaps, some argue, the ‘Sahm Rule’ will be wrong this time, insofar as a rise in the unemployment rate due to a rising participation rate is a plus.
One thing, however, is abundantly clear. Rising unemployment, softer wage gains, weakness in manufacturing, and plunging oil prices significantly increase the odds that US inflation will continue to fall.
Accordingly, the Fed will surely now cut interest rates, with the first move coming at its next meeting in September. Moreover, cuts are likely in subsequent meetings this year and next.
It is also possible and increasingly warranted for the Fed to accelerate its easing with several 50 basis point cuts, rather than proceeding with its customary quarter-point reductions. There is, after all, little risk in doing so, as inflation is likely to remain subdued. At the same time, there is considerable risk to moving too slowly, which could compound the Fed’s unfolding policy error.
Finally, there is the ugly matter of politics. If the Fed begins to aggressively ease, its moves will be heavily criticized by former president Trump and the Republican Party for being ‘partisan’ (i.e., helping Kamala Harris). But if the economy sinks into recession, criticism of the Fed by Democrats is likely to be withering, as well.
Pity Fed Chairman Powell. He was poised to be hailed as the central bank gold medalist who stuck the soft landing. Now, he’s likely to be pilloried as the monetary gymnast who waited too long and landed on his keester instead.
Who said competition was easy?
