This was made clear in a speech Williams gave before a virtual event hosted by the Economic Club of New York earlier this week. Williams predicted that the Fed would need to keep raising interest rates into next year and possibly hold them at that higher level into 2024 to govern the highest inflation in four decades. Pretty standard stuff. What he said next wasn’t that standard. Williams added that the unemployment rate would likely rise next year from the very tight current level of 3.7% to a more sustainable range of 4.5% to 5%, resulting in a “modest” expanding economy.
The problem with that last statement is that it suggests that the economy would be breaking the Sahm Rule. The rule is a bit technical, but essentially it says that if the unemployment rate rises more than half a percentage point in a year from its three-month average, the economy is entering a recession — if it’s not already in one. And yet Williams’ comments imply that even with his forecast of a sharp rise in the unemployment rate, a recession would be avoided.
Well, it could be that Williams chose his words very carefully, expecting the softest scenario to prevail, with the unemployment rate rising slowly and only dipping into the lower end of the 4.5% to 5% range like last year passes comes to an end. This, Williams said, would allow the economy to achieve the fabled soft landing and slow down just enough to bring inflation back under control, but not enough to trigger a recession.
But that logic is strained and at odds with the macroeconomic forces that give the Sahm rule its power. Underlying the rule is the observation that a recession is not simply a period of no growth, but a breakdown in the normal and healthy processes that underlie a market economy. Since 1948 and the onset of reliable data, there have only been a handful of times when the unemployment rate has been essentially stable for any length of time. In the year and a half from spring 1955 to summer 1956 and in the two years from December 1966 to December 1968, the unemployment rate averaged over a three-month period 4.1% and 3.8%, respectively. Over any other prolonged period, the rate either falls or rises sharply into a recession. Throughout the history of data collection, there has been no clear evidence of a slow increase.
Why is the unemployment rate so rarely stable over a long period of time? First, businesses and consumers in general are reluctant to change their spending and employment practices when a temporary drop in income or demand might materialize. So consumer spending continues, allowing companies to keep employees on the payroll, which in turn gives consumers a more stable income, and the cycle repeats itself. However, this two-sided reluctance only endures so much stress. Once the breaking point is reached, it starts a self-reinforcing cascade in the opposite direction. Consumers are cutting back drastically, forcing companies to lay off more, which in turn eats away at consumer incomes.
Now look at the current economy. Consumer spending has held up well, but that’s likely due to the unprecedented accumulation of about $4 trillion in excess savings during the pandemic — money that has helped households weather the shock of faster inflation and higher borrowing costs. Likewise, the labor market is unusually resilient, but that comes after a period when companies have struggled to attract staff. So it stands to reason that employers will be reluctant to lay off staff if the economy avoids a recession and picks up again. The implication is that consumers and businesses may be able to weather the current series of major economic shocks, just as they have weathered minor shocks in normal times.
Yet the Fed is raising rates precisely because it wants consumers to adjust their budgets sharply downwards. Williams’ prediction that the unemployment rate will rise to a range of 4.5% to 5% suggests companies will respond to such a structural demand slump by shedding jobs. In other words, the first step in the self-reinforcing cascade leading to recession is a necessary consequence of the Fed meeting its targets.
So, not only is a recession inevitable, but what looks like resilience in both consumer spending and the labor market is actually a reflection of large and sweeping adjustments. That doesn’t mean the economy is doomed, as the Fed and Williams could be wrong about the source of inflation, but it does mean that those hoping the Fed can stall the job market are without the broader economy upside down to ask this ghost should give up. More from Bloomberg’s opinion:
• Fed slowdown doesn’t get much help from Big Tech: Conor Sen
• Quiet Quiet is a False Workplace Trend: Sarah Green Carmichael
• Stagflation is what the US economy needs: Narayana Kocherlakota
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Karl W. Smith is a columnist for the Bloomberg Opinion. Previously, he was vice president for federal policy at the Tax Foundation and an assistant professor of economics at the University of North Carolina.
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