Right now, every economist, investor, or anyone paying attention to all the economic data that comes out is hoping to find proof that inflation is on a trajectory toward the Fed’s 2% target. Giving the Fed the green light to lower interest rates, which we then hope means the economy can have its soft landing and avoid a recession without an increase in unemployment. But when you look at the history of monetary policy, it warns that recessions and rises in unemployment don’t start during the monetary tightening cycle but, in fact, begin when the Fed begins to ease monetary policy and lowers interest rates.
In fact, since 1954 ten times have circumstance arose that required the Central Bank to significantly raised interest rates to counteract inflationary pressures. In each of these instances, it has consistently been the case that during the subsequent easing phases of the Central Bank's monetary policy, that the economic pendulum has swung back with tangible impact—and 10 out of 10 times, the easing phase has been marked by the onset of a recession coupled with a notable uptick in unemployment rates. Jerome Powell, Chairman of the Federal Reserve, understands this well and has said many times in press conferences that an increase in unemployment is an unintentional but often necessary consequence of the tight monetary policy that is required to fight against inflation. He also emphasized that the Central Bank was prepared and even predicted an increase in unemployment on the path to achieving their price stability goals.
Why does this occur? Our exploration will reveal that the complex interplay between the business cycle and monetary policy is the culprit. These forces work in tandem, sculpting the periods of economic growth and decline that signal the potential onset of a recession and the fluctuating conditions of the labor market.
Grasping the nuances of this relationship is crucial for untangling the enigma of economic contractions and the occasionally counterintuitive rise in unemployment that can ensue following shifts in monetary policy. As we analyze the cycle itself, it becomes imperative to comprehend how each segment mirrors human behavior and the health of the larger economic climate, both influenced by variables like consumer sentiment, the accessibility of credit, and both monetary and fiscal policy strategies.
The Business cycle:
Phase 1: Expansion
A business cycle works in four phases: expansion, peak, contraction (recession), and trough. Let's commence with the expansion phase, starting with the expansion phase, which can be characterized by increasing economic activity and growth. During this juncture, monetary policy tends to be stimulative; low-interest rates incentivize investment over saving, and this dynamic encourages banks to lend liberally to consumers and businesses alike. Such conditions swell the supply of money and credit, fueling individuals and businesses to escalate their consumption of goods and services and the purchase of financial assets. This symbiosis between spending and income propels an upturn in income levels and a sense of increased wealth as asset values burgeon and wages rise. One person's spending is another person’s income. With consumer confidence surging, the robust growth of the economy is mirrored in sustained upticks in spending and borrowing. This bolstered demand galvanizes businesses to augment profits by enhancing production, investing in new technologies, launching additional facilities, and enlarging their workforce, thus broadening job availability in the market. As a result, industrial and manufacturing output swells alongside capacity utilization, driving an uptick in GDP growth rates. Amid this economic opulence, banks, buoyed by optimism and rising asset values, such as homes and stocks, find individuals and businesses increasingly creditworthy. This confidence leads to an expansion of credit provision, which in turn perpetuates the cycle of economic expansion.
This is where we were in 2021. As the world emerged from the grips of the pandemic, central banks, mimicking the stimulative tactics typical of expansion, cut interest rates to spark economic activity, support financial markets, and maintain the liquidity and flow of money and credit. Fiscal policies complemented these efforts with legislative actions from Congress that injected stimulus payments, increased unemployment benefits, and provided businesses with PPP loans, thus handing individuals and companies a lifeline of additional disposable income. These moves sustained consumer spending and investment, essential indicators of expansion. Mirroring the cyclical upturn, the stock market experienced a bull run, soaring by 25%, as investors, flushed with excess capital, turned to asset acquisition. With historically low mortgage rates, the housing market boomed, triggering a 16.9% appreciation in home values across the nation over the year — a clear reflection of burgeoning economic confidence and wealth accumulation seen in an expansion phase. Businesses capitalized on this revived consumer demand by scaling up operations, echoing the increased production and capacity utilization that signify an economic upswing. GDP growth, charting a 5.42% climb, underscored this vigorous expansion. Employment, a lagging indicator, also portrayed a significant recovery, with the creation or restoration of 6.4 million jobs as firms ramped up hiring to meet production needs, driving down unemployment from its previous pandemic-induced peak of 14%.
Phase 2: The Peak
The next stage in the business cycle is the peak, also referred to as the bubble phase. As a consequence of stimulative monetary policy and fiscal stimulus, the expansion of money and credit soon accelerates faster than productivity. This rapid expansion of money and credit furthers the momentum gained during the expansion phase and boosts incomes and asset values further, elevating consumers' and businesses' creditworthiness and enabling them to have an increasingly higher capacity to spend. This fosters a climate where excessive capital vies for a finite array of goods, services, and financial assets, fueling inflation and speculative bubbles.
As human nature would have it, people often think that euphoria is going to last forever. As creditworthiness is at an all-time high due to an increase in net worth from asset bubbles and wage increases, many ignore the signs and borrow more to purchase more financial assets or goods and services. Businesses, seeing the sustained consumer demand and capacity to spend, get greedy for profits, increasing prices, which creates inflation and expanding production and capacity by creating more jobs and hiring more workers which pushes down unemployment rates.
As the bubble nears its breaking point, the price of goods and services begins to inflate disruptively and outpace wages, leading to constrained affordability. This is when the central bank steps in to enforce one of its dual mandates—"Stable Prices"—by implementing restrictive monetary policy, raising interest rates, and removing liquidity from the banking system with the intention of slowing down the economy and, in turn, curbing inflation.
As interest rates rise, debt burdens increase, and consumers are forced to decrease their spending on goods and services in order to pay down their debts. At the same time, the interest paid on deposits or money market accounts increases, making saving money more attractive than borrowing, leading to a further softening of demand for goods and services. Again, one person's spending is another person's income. Hence, as demand for goods, services, and financial assets softens, so do business profits and asset valuations, and eventually, creditworthiness deteriorates, leading to the next part of the cycle: contraction (recession).
This is where we were in 2022. Home prices rose another 14% before peaking in May 2022; the S&P climbed to 4,818 in January 2022, up 109% from its trough in March 2020. Wage growth reached its zenith in 2022 as well, increasing by around 8%; this period was also the time when we saw inflation rear its ugly head; the consumer price index peaked in June 2022 at 9.1% on a year-over-year rate. This imbalance caused real wage growth to go negative, and the cost of living began to outpace the increase in people's incomes, restricting their ability to spend. We began to see the effects of this as balances on consumers' revolving debt instruments, such as credit cards, increased, especially in the lower-income sector of the economy.
The stark rise in inflation caused the central bank to initiate its first round of rate hikes in March 2022. This marked the beginning of the end of the bubble as the central bank raised rates continuously and at the most aggressive pace in history, 22 times in 18 months. And that brings us to where we have been since July 2023. Currently, monetary policy is very restrictive. How restrictive, you might ask? The central bank's federal funds rate has a target range of 5.25%-5.50%; this has undoubtedly had a positive impact on inflation, as the core PCE, the Fed's preferred measure of inflation, is at an annual run rate of 2.5 percent on a 6-month rolling average. But this also means that there is a 300 basis point difference between the rate of inflation and the cost of borrowing.
When the Fed funds rate is at 5.5%, it reflects the annual percentage rate banks are charging when lending money to each other overnight. As the rate increases, it also leads to higher interest rates for consumers and businesses as well who want to borrow money, depressing demand for loans by increasing the overall cost of credit. On the other hand, inflation being at 2.5% means the cost of goods and services is rising at a slower pace than the federal funds rate. Putting these two pieces together, borrowing money becomes less attractive because it's expensive to pay back loans with high interest. Meanwhile, saving money becomes more beneficial. Why? Because the money you save can earn interest at these higher rates, and since inflation is lower, the value of the money you save doesn’t lose as much purchasing power over time. Essentially, your saved money can grow faster than the cost of living is rising.
Consequently, businesses and consumers alike become more conservative, spending less and saving more, leading to a reduction in economic activity. This reduction in demand leads to the third stage of the business cycle: contraction.
Phase 3: Contraction
The contraction phase marks a pivotal shift in economic momentum. Despite the central bank’s cessation or reversal of interest rate hikes, the economy, like a high-velocity train, cannot abruptly alter its course. The well-established principle of long and variable lags in monetary policy dictates that even as inflation begins its descent to more palatable levels and the central bank adjusts its stance by easing the reins on interest rates, the economy does not pivot on a dime. The lingering effects of prior rate hikes and the restrictive environment they fostered have set in motion behavioral shifts amongst businesses and consumers alike—a momentum that endures. These changes in behavior, while not immediately perceptible, manifest over time, often spanning a period of 18 to 24 months after the last rate hike, meaning that the full impact of monetary policy decisions unfolds not in step with their implementation but across a stretched horizon, reflecting the inherent inertia within the economic system.
During contraction, the central bank has typically maxed out its policy tightening and aims to pivot towards rate cuts. Even if inflation indicators suggest a downtrend, the economy still reels from the impacts of previously higher prices. A reduction in inflation merely slows the pace of price increases; it doesn't translate to a decrease in prices. As a result, consumer confidence continues to erode, with spending declining sharply as the cost of living remains elevated against a backdrop of stagnant wage growth.
Heightened consumer and corporate debt burdens, compounded by higher interest expenses induced during the bubble phase, prompt a conservative shift in spending behaviors. The need to manage debt repayments leads individuals to prioritize debt reduction over consumption, perpetuating a cycle where diminished spending reduces others’ incomes. This, in turn, triggers a forced liquidation of assets, exacerbating the issue as increased supply outstrips demand, resulting in a depreciation of asset values.
The ripple effects on demand flow through the business landscape. Companies grappling with profitability concerns scale back production and initiate cost-cutting measures—layoffs being the most direct and significant. This contraction in labor demand cascades through the supply chain, causing suppliers to also reduce their workforce. The cumulative effect decays the job market, making it increasingly challenging for individuals to secure employment.
This confluence of factors sets the stage for unemployment to rise post-rate cuts. It is a reflection of the economy's inertia, where debt aversion and spending reticence dominate, suppressing the appetite for borrowing, investing, and hiring. In this environment, a recession becomes a self-fulfilling prophecy, not because of the central bank's lowered rates per se, but because of the economic momentum that those rates have been trying to guide.
The surge in unemployment following rate reductions is a testament to the enduring influence of the business cycle. It's a cycle driven by the collective memory of the economy—a memory that doesn’t fade with a mere policy change but requires a substantial and sustained shift in economic conditions to reset.
Although the economy in many ways remains resilient—we have seen the stock market rebound and reach new all-time highs, though this can mostly be attributed to Chat gpt’s polarization of AI leading to technology, automation, and computer chip companies carrying most of the weight, and the stabilization of the housing market—we are just now starting to see signs of softening in the labor market. This is what we are on the cusp of, as monetary policy has been restrictive since July 2023.
The labor market is showing signs of stress, indicated not only by a stable level of initial jobless claims but, more tellingly, by the rise in continued claims. At the time this report was written, the average initial jobless claims hovered around 212,000, akin to pre-pandemic 2019 levels; the deeper issue lies in the elevated continuous jobless claims. In the first week of March, the four-week average rose by 10,250 to 1.888 million—the highest level since December 2021. It underscores a growing difficulty for the unemployed to find new jobs, signaling a cooling labor market that could be a precursor to broader economic challenges.
This contraction in employment opportunities is supported further by the gradual decline in job openings. While job openings remained robust post-pandemic, with March 2022 showcasing a high of 12 million available positions, a ratio of two jobs for every job seeker, this buoyancy is waning. The current figure stands at 8.9 million—a still substantial but gradually decreasing number.
Another leading indicator of a softening labor market is the frequency and acceleration of layoffs, which we began to see rather early, taking shape in October 2022, according to the recent Challenger report. The technology sector shed 50,000 positions in a single month, a prelude to a broader trend.
In 2023, a wave of layoffs swept across major firms, culminating in more than 305,000 job losses, with industry giants such as Amazon, Microsoft, Meta, and Google each cutting upwards of 10,000 jobs. In February of this year, 84,638 planned job cuts were announced, a February figure not seen since the 2009 financial crisis, further cementing this troubling trajectory. Year-to-date figures reveal alarming spikes in job cuts within several sectors:
Financial firms have disclosed 26,856 layoffs, a 56% increase from the previous year.
Industrial Goods Manufacturing reports a staggering 1,754% rise with 7,806 cuts.
The Energy sector’s layoffs have surged by 1,059%, totaling 4,486.
In Education, the number of job cuts has escalated by 944%, reaching 6,336.
Transportation has seen layoffs increase to 14,148, a 587% uptick.
Food Manufacturing layoffs have climbed by 355%, totaling 9,824.
The labor market's pulse is notably slowing, with wage growth deceleration serving as a clear indicator. A 2023 report from ZipRecruiter revealed that nearly half of the surveyed U.S. companies had reduced salaries for certain roles. This trend aligns with the broader narrative of dwindling demand for labor, a stark contrast to the vigorous wage growth witnessed at the start of 2022, when it wages surged 9.3% year-over-year. However, as per Indeed's insights, by January 2024, this growth rate had precipitously declined to 3.6%, signaling a downward trajectory that has yet to find its nadir.
Industries that previously experienced fierce competition for talent during the hiring spree, such as hospitality and retail, are exhibiting this shift most acutely. These sectors saw wage growth rates plunge from 11.8% in February 2022 to just 3.4% by January 2024—a near fourfold decrease. Moreover, the deceleration is most severe within low-wage brackets, where posted wages have tumbled from an annual high of 12.5% to 3.4% by February of the following year. Despite this downturn, according to ZipRecruiter analysis, wages in these sectors are still maintaining growth above pre-pandemic levels, and are current at or slightly above the current level of inflation, though the sustainability of this trend remains uncertain.
To provide perspective, wage growth for high-wage roles retracted from a zenith of 8.2% to a mere 2.6% in February, while middle-wage workers saw their year-over-year wage growth curtailed to 3.9% from a peak of 8.5%. This broad-based moderation in wage inflation reflects a significant shift in labor market dynamics, as the negotiating power that workers held in a tight labor market begins to diminish, aligning with the softer demand for labor across the economic spectrum.
Phase 4: The Trough
So, what could the future hold? Once the economy and labor market have lived through the contraction phase, we would then approach the trough—the subfloor of economic activity where the contraction phase bottoms out. Here, the cumulative effects of tightened monetary policy, subdued consumer spending, and a contraction in the labor market are most palpable. The trough in the business cycle represents the lowest point of economic activity, which typically occurs after a period of contraction. When the economy reaches the trough, key indicators of economic health—such as GDP, employment, industrial production, and retail sales—have often fallen to their lowest levels. It is characterized by significant underutilization of resources, high unemployment rates, decreased consumer confidence and spending, and reduced business profits.
The trough phase could manifest as a persistent malaise in the job market, where despite a deceleration in layoffs, the absence of robust job creation prolongs the plight of the unemployed. Wage growth may continue to languish, reflecting an oversupply in the labor market where bargaining power firmly shifts back to employers. The sectors that once boomed riding high on the wave of economic expansion, might now face the most significant challenges, particularly those that are cyclical in nature and sensitive to consumer discretionary spending.
Although painful, this stage in the cycle is crucial because it often serves as a turning point where the economy stabilizes before beginning to recover. It’s a period marked by a realignment of supply and demand, where excess inventories built up during the contraction are sold off, often at lower prices. Businesses may operate below capacity, and investment is usually subdued as companies and investors remain cautious due to recent economic hardships.
With the economy suffering during the trough phase of the business cycle, monetary and fiscal policies would likely become expansionary again. The Fed would lower interest rates to historic lows to make borrowing cheaper, aiming to stimulate spending and investment. Meanwhile, governments may increase spending or cut taxes to spur economic growth. These policy measures seek to inject liquidity back into the market, encourage lending and spending, and boost consumer and business confidence, laying the groundwork for recovery and a return to the expansion phase.
However, the time it takes for these policies to translate into economic improvement can vary significantly. The labor market often lags behind other economic indicators; even as the economy starts to recover, unemployment may remain high until businesses are confident that the recovery is sustainable and begin hiring in earnest. It's often said that unemployment takes the elevator up but takes the stairs back down to normalcy.
Reflecting on monetary history, we've seen that recessions and rises in unemployment often trail the Federal Reserve's tightening cycles, becoming most pronounced as the policy shifts to easing. If this pattern holds true in the current cycle, it could challenge the 'soft landing' many are anticipating. This highlights the critical understanding that monetary policy operates with significant lags—effects that are felt long after the policies are enacted, often taking 18 to 24 months to fully manifest.
It's important to note that the trough phase is not always easily identifiable in real-time; it's often only recognized in hindsight through economic analysis of past data. During this phase, while growth has not yet restarted, the decline has ceased, and the economy is positioned for the upcoming upswing that characterizes the next expansion phase. This cycle of downturn and recovery emphasizes the resilience of economies to self-correct and discover new paths to growth after periods of contraction.
In conclusion, this analysis isn't a forecast; it presents an unbiased context on the cyclical nature of the economy and employment, emphasizing the intricate interplay between monetary policy and its subsequent impact on the labor market. While history can guide us, the future may present a different outcome than the widely predicted soft landing, especially if these cyclical patterns continue. As vigilant observers of the economy, our role isn't to predict with certainty but to prepare, adapt, and respond to the economic shifts with the insights that history has provided us.
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