WASHINGTON – The turmoil shaking global financial markets reflects a sudden fear that the Federal Reserve may have held its key interest rate too high for too long, heightening the risk of a U.S. recession.
Economists and Wall Street traders now expect the Fed to cut its benchmark rate, which influences borrowing costs for consumers and businesses, much faster than they thought just a week ago. Chair Jerome Powell has often stressed that the Fed could quickly lower rates if it decides that it’s needed to bolster the economy.
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Yet the periodic fear of a forthcoming recession has been a hallmark of the post-pandemic economy — and has proved wrong every time. Instead, contrary to what most analysts have predicted, steady economic growth and a solid pace of hiring have endured.
In the past, the U.S. economy would often flash telltale signals when it was in or near a recession. But those red lights have gone haywire since the COVID-19 pandemic struck and upended normal business activity.
The latest red flag was Friday’s July jobs report from the Labor Department, which showed that the unemployment rate rose from 4.1% to 4.3% — still a relatively low level but the highest rate in nearly three years. Markets panicked after the report was released, in part because it set off the so-called Sahm Rule.
Stocks tumbled again on Monday, after share prices overseas had plunged. The Dow Jones index plummeted more than 1,030 points, or 2.6%.
Named for Claudia Sahm, a former Fed economist, the rule has found that since 1970, a recession has always been underway once the three-month average unemployment rate has risen by half a percentage point from its low of the previous year. The logic behind the rule is that unemployment can be self-sustaining: As more people lose jobs, they cut back their spending, harming other companies, which then stop hiring or even cut workers.
Yet the Sahm Rule could be yet another recession signal that turns out to be a false alarm. Sahm herself doubts that a recession is imminent.
The rule is typically triggered when companies start cutting jobs, thereby raising the unemployment rate. Yet now, unemployment has been rising not because companies are slashing jobs but because so many people have poured into the job market. Not all of them have found work right away.
Jay Bryson, chief economist at Wells Fargo, thinks the risk of recession has risen along with the unemployment rate. But he ultimately thinks the economy will pull through.
“The good news here," he said, "is that there haven't been any major shocks hitting the economy,” such as a spike in oil prices or a housing bust. “Absent a shock, it's a bit more challenging to get into a recession.”
Other previously notable recession indicators that have flopped in the post-pandemic era include:
— A bond market measure with a dry-as-dust label: The “inverted yield curve.’’
— The rule of thumb that two consecutive quarters of shrinking economic output amount to a “technical recession.’’
Last week, Powell said that while he was aware of the Sahm Rule and its implications, other recession signals, such as changes in bond yields, haven’t been borne out in recent years.
“This pandemic era has been one in which so many apparent rules have been flouted,” he said at a news conference. “Many received pieces of received wisdom just haven’t worked, and it’s because the situation really is unusual or unique.”
Powell spoke after the central bank kept its key rate unchanged but signaled that it could reduce the rate as soon as the next policy meeting in September.
Financial markets and most economists now think the Fed will end up cutting rates fairly quickly this year, in part to offset economic weakness.
Bryson expects half-point cuts in the Fed's benchmark rate in September and November and an additional quarter-point cut in December. That is much faster than Wells Fargo's previous forecast of just two quarter-point rate cuts this year, in September and December.
Some analysts have speculated that the Fed could reduce its rate at an emergency meeting before September. But most economists doubt that the officials would take such a step, unless there were further signs of economic weakness.
“Historically, the (Fed) has as only delivered inter-meeting cuts ... when there was a clear negative shock or when the data were worse than they have been so far,” Goldman Sachs economist David Mericle wrote in note.
For four years, economists have struggled to make sense of an economy that was first shut down by the COVID-19 pandemic, then roared back with such strength that it revived inflationary pressures that had lain dormant for four decades. When the Fed moved to tame inflation by aggressively raising rates starting in March 2022, economists almost uniformly predicted that the higher borrowing costs would cause a recession.
The central bank raised its rate 11 times in 2022 and 2023, and the phenomenon known as the “inverted yield curve” soon followed. An inverted yield curve occurs when the interest rate on shorter-term Treasury bonds, such two-year notes, rises above the rate on a longer-term bond, such as the 10-year Treasury. That happened in July 2022, and yields remained inverted until Monday, when the 2-year briefly fell below the 10-year yield.
Typically, longer-term bonds have higher yields to compensate investors for locking up their money for an extended period of time. When shorter-term bonds start paying out higher yields instead, it usually occurs because markets expect the Fed to crank up its short-term rate and keep it high to quell inflation or cool the economy. Such steps often lead to a recession.
An inverted yield curve has preceded each of the last 10 recessions, according to Deutsche Bank, usually by about one to two years. It did provide one false signal in 1967, when an inversion occurred but no downturn followed.
Tiffany Wilding, an economist and managing director at bond giant PIMCO, says one reason it hasn't worked this time is that the government’s huge financial assistance packages, totaling roughly $5 trillion in 2020 and 2021, enriched consumers and business alike. As a result, they have been able to spend and invest without borrowing as much, muting the impact of the Fed’s rate hikes and dulling the signal from the inverted yield curve.
Also in 2022, the government reported that gross domestic product — the economy’s output of goods and services — had fallen for two straight quarters, a longtime rule of thumb that has often accompanied a recession.
The top-line economic numbers did show that economic output was falling. But another measure in the GDP report told a different story: Stripping out volatile items such as inventories, government spending and imports, it showed that the underlying economy continued to expand at a healthy pace.
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AP Writer Josh Boak contributed to this report.