LONDON, Sept 17 (Askume Breakingviews) – No problem, everything will be fine. That’s the surprising message from U.S. and European labor markets over the past two years. Unemployment has remained low despite rapidly rising interest rates. This has led central banks on both sides of the Atlantic to believe they can achieve a “soft landing” for the economy by defeating inflation without triggering a deep recession. Their problem is that the amazing resilience of the workforce is showing signs of breaking down. Once that happens, an economic contraction usually follows.
“Unemployment is like a headache or a high fever—unpleasant and tiring, but not in itself explaining its cause.” British economist William Henry Beveridge famously overturned the definition of unemployment . Labor market conditions have been very good in most Western economies since the pandemic ended, surprising central bankers and Wall Street.
Finally, the Federal Reserve and the European Central Bank raised interest rates in response to economic disruption related to the pandemic and higher inflation caused by Russia’s invasion of Ukraine. Higher borrowing costs typically reduce demand for goods and services, causing companies to lose revenue and prompting them to cut costs through layoffs. The newly unemployed are tightening their belts, further reducing corporate sales and hurting economic growth. This negative cycle will eventually end when interest rates fall again.
However, things are different this time. The Federal Reserve began raising borrowing costs in early 2022, pushing them to a 23-year high. But during this period, the US unemployment rate has mostly remained below 4%, well below the average of 5.7% since 1948. In the euro zone, borrowing costs hit a record high of 4% in September 2023, but the unemployment rate has been hovering near a record low of 6.4% for 18 months.
At the same time, both groups have recovered quickly from pandemic-induced recessions. In the second quarter of 2024, US GDP will grow at an annual rate of 3%. The euro zone suffered a brief contraction in 2022, but grew by an annualised 0.6% in the three months through June.
The most convincing explanation is that companies refuse to lay off workers even when there is not enough work to do. The data supports this “labor accumulation” argument. In March 2020, as the pandemic spread globally, US companies laid off more than 13 million people. A year later, that number fell to about 1.4 million and has remained at that level ever since. A survey by Business RoundtableAccording to the data , nearly half of US CEOs want to maintain a stable workforce. In Europe, the proportion of companies expecting production to fall but employment to remain stable during the pandemic reached a record 31%.
It is less clear why companies are so reluctant to lay off unneeded workers. One possibility is that business leaders are hurt by difficulties in recruiting workers after the pandemic. Another reason is that there is not much fat to lose. Unlike previous recessions caused by excesses, the external challenges posed by COVID-19 and the war in Ukraine have not required widespread cost cuts. The resilience of US and European corporate profits, which have also benefited from massive fiscal stimulus, supports this view.
But this employment fairy tale may not have a happy ending. Alarm bells have rung louder in the United States, and the inevitable indicators of an economic recession have begun. The rule, named after former Fed economist Claudia Sahm , states that the US economy will be in recession when the three-month moving average unemployment rate rises by at least 0.5 percentage points from the lowest point in the past 12 months or shrinks by that much. Sahm’s rule has accurately predicted every US recession since the 1970s, which began when the unemployment rate reached 4.3% in July .
Clouds are also looming in Europe. Data from Gavekal Research shows that less than 10% of companies are furloughing employees, and corporate profitability has fallen below long-term averages. According to a survey of 5,000 companies by S&P Global , companies in the euro zone are expected to reduce the number of employees for the first time since the beginning of 2021.
These may be false positives. The US unemployment rate fell to 4.2% in August. The previous increase may have been due to a surge in immigration that increased the labor supply. Goldman Sachs analysts estimate that about 3 million immigrants will enter the United States in 2023, up from about 1 million a year before the outbreak. If the newcomers find jobs, the unemployment rate may fall to lower levels. The Fed is also preparing to cut interest rates, possibly as soon as this week. In Europe, the European Central Bank has lowered borrowing costs.
But the risks are rising, and not only because, as economists Robert E. Hall and Mariana Kudlik wrote in a 2021 paper , “the unemployment rate is rising like a rocket, falling like a feather. A sustained rise in unemployment could lead to a vicious cycle.”
Job openings in the United States are at their lowest level since January 2021. Former New York Federal Reserve President Bill Dudley told analysts at Goldman Sachs that once the SAM rule is implemented, the unemployment rate could rise sharply by 1.9 percentage points. This would push the ratio above 6% – a level not seen since 2021. A study by the Federal Reserve Bank of San Francisco shows that over the past 75 years, for every 1% increase in the US unemployment rate, GDP has declined by an average of 1.5%. Therefore, a rise in unemployment, as Dudley predicts, would derail the economy, as GDP is currently growing at a rate of 2.5% annually, according to the Atlanta Fed. Rising unemployment in Europe appears to be having a more modest impact on economic growth , but the bloc’s weak growth rate means even a limited recovery could push it into recession.
Central banks can plan for a soft landing by cutting interest rates. But if their measures take too long to take effect, rising unemployment could spell trouble for the United States and Europe.
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