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Tuesday, February 7, 2023

Recession looms as labor retains upper hand, Kenan Institute chief economist says

This is the time of year when many companies are finalizing budgets for next year. Expenses are not that hard to forecast. But the revenues depend on customers and the economy.

Putting a budget together is harder than usual right now, with recession talk in the air.  I got insights on what might happen from Gerald Cohen,  chief economist at the Kenan Institute of Private Enterprise at UNC Chapel Hill.  Cohen briefed reporters Friday morning after the latest jobs numbers were released by the U.S. Bureau of Labor Statistics, showing that the economy added 263,000 jobs last month and the national jobless rate, unchanged at 3.7%, is still close to 50-year lows. You can watch the briefing here.

Gerald Cohen

The larger context is this: The labor market is very tight. Inflation is still high. And the Federal Reserve is almost certainly going to keep raising interest rates next week.

Cohen was pretty certain there will be a recession. The metric that suggests that is the yield curve, and the negative spread between the 10-year Treasury note and 3-month Treasury bills. The yield curve plots the return on Treasury bills and notes and bonds of increasing durations. Usually, it is upward sloping. Think of the Y axis as interest rates and the X axis as time; the longer you are lending money to the government, the higher the interest rate you want. So as the debt securities increase in maturity, the interest rate climbs up the Y axis, and the line through all the dots slopes upward. Typically.

But right now, the yield curve is inverted – downward sloping – because 3-month T-bills are paying a higher yield – 4.298% – than 10-year notes, 3.585%. That happens because investors think the economy is going to weaken significantly and so there will be less borrowing a few years from now.

Yield curve inversions have predicted the last eight recessions, as defined by the National Bureau of Economic Research – the private group of economists that decides when we’ve had a recession.

Economists pay attention to the difference between treasuries of different maturities, like the 10-year and 2-year, or the 10-year and the 3-month, the “spread.” Because the yield on the 3-month now exceeds the 10-year, this is a so-called “negative spread,” around -0.71% as of Monday.

‘It just decisively turned negative a month ago,” said Cohen. That tells him that a recession is coming. “It has predicted every recession since the mid-1960s,” he said.

“My favorite indicator suggests that it is likely to be in the next year or two,” said Cohen.

We are not in a recession now. In the first half of this year, the economy had two consecutive quarters of negative growth. But that, by itself, isn’t a recession, even though a lot of people think it is. That is not what the NBER looks at to assess turning points in the business cycle. It is more focused on whether the economy is adding or losing jobs, and other variables, like personal income levels, and manufacturing activity.

While most of the jobs data on Friday showed continued growth, there were some signs of a possible slowdown that were mentioned by Cohen. Temporary help declined in November by 17,200 workers nationwide. That’s not a huge drop – there are 3.1 million temps – but temps are often the first to go when companies start reducing expenses. It can be a leading indicator.  But Cohen cautioned about relying too much on that data point. “It’s hard to read temporary help given the shortage of labor, because companies could be having trouble finding people, because there are so few people out there.”

Another sign of a possible loosening in the jobs market came from the job opening numbers last Wednesday, the JOLTS report, showing a 3.3% drop between September and October.  But the number of openings, 10.3 million, is still high. Pre-Covid, in February 2020, there were 7 million openings.  And in the depths of the Great Recession, in mid-2009, there were just 2.2 million, to give you some idea of where we’ve come since then.

The challenge for the Federal Reserve is in the hourly earnings data that came out in the jobs report Friday. The year-over-year wage increase for all employees was 5.1%.  “But it’s not keeping up with inflation, and this is the Fed’s big worry, that we’re going to get this wage-price spiral, where people are saying ‘I need higher wages to keep up with inflation.’

“Companies need to raise prices to keep up with the wage gains, and that causes workers to want higher wages, and it spirals,” said Cohen. “And that’s one of the biggest worries of the Fed is inflation continues to be persistently high.”

Last week, the Personal Consumption Expenditures index showed that prices for goods and services were 6% higher in October than October 2021, which was a slight improvement over September, 6.3%. With volatile food and energy prices removed, the October increase was 5%, better than September’s 5.2%.  This is the inflation metric that the Fed monitors most closely, and it is still significantly higher than the central bank’s 2% inflation target.  So even though it showed inflation slowing a little, it isn’t falling fast enough to suit the Fed after six interest rate hikes since March, including an aggressive four straight hikes of three-quarters of a point since June.

“Goods inflation accelerated but now is coming down,” said Cohen.  “Services inflation has picked up. And the problem is that services are a bigger part of our spending basket, so the fact that this is accelerating means that inflation is not coming down despite the fact that goods have decelerated.”

Based on Friday’s jobs report and Wednesday’s job opening numbers, “employees still have the upper hand in terms of negotiation,” said Cohen.

“Now you could argue that employers could push back and say, ‘Well, we’re potentially headed towards a recession, so you might want that job.’ and not be willing to give as great wage gains. But if they’re looking for workers, employees still have the upper hand.  The labor market, I would say, is tight as a drum. There are some signs that there may be a little bit of loosening, but it’s still super tight.”

Cohen said he expects that the coming recession will be relatively mild, for several reasons.

Manufacturing usually gets hit hard during recessions. “But this might be a bit different, because there have been so many supply constraints that companies are still trying to meet demand, and so the downturn in manufacturing may be less than you may see historically in recessions.”

Also, the underlying fundamentals of the economy are strong.

“Households have built up a very high level of savings during Covid because they didn’t spend . . . and because fortunately we had some support.  Versus 2008, when we were very highly leveraged. High levels of borrowing are accelerants to recessions, and we don’t have that,” said Cohen.

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