Rising unemployment rocks stock markets, but recession signals are wrong

WASHINGTON (AP) — An unexpected rise in the U.S. unemployment rate last month roiled financial markets and raised fresh fears of a looming recession — but it could also turn out to be a false alarm.

Friday’s jobs report, which also showed a slowdown in hiring last month, comes amid other signs that the economy is cooling amid high prices and higher interest rates. A survey of manufacturing companies showed activity weakened markedly in July. But Hurricane Beryl hit Texas the same week the government compiles employment data and may have held back job growth.

READ MORE: US employment is falling, only 114,000 jobs added in July, unemployment rate reaches 4.3 percent

The U.S. economy used to send reliable signals when it was in or near recession. But those red lights have been in disarray since the COVID-19 pandemic hit and upended normal business operations. For the past two or three years, they signaled declines that never came because the economy simply kept growing.

Recession fears are also quickly becoming politicized, especially as the presidential election heats up. On Friday, former President Donald Trump’s campaign said the jobs report was “further evidence that the Biden-Harris economy is failing Americans.”

For his part, President Joe Biden said the economy has added nearly 16 million jobs since he and Vice President Kamala Harris took office, while the unemployment rate has fallen to its lowest level in a half-century. Some of that job gain reflects a rebound from the pandemic, but the U.S. now has 6.4 million more jobs than it did before COVID-19.

Still, Friday’s U.S. Labor Department report is rekindling fears of a recession. The Dow Jones Industrial Average fell more than 600 points, or 1.5%, on Friday, while the broader S&P 500 fell nearly 2%.

Markets likely panicked in part because when the unemployment rate rose to 4.3 percent last month — its highest level since October 2021 — the so-called Sahm rule was triggered.

Named for former Fed economist Claudia Sahm, the rule states that a recession is almost always underway if the three-month average unemployment rate rises by half a percentage point from the previous year’s low. It has been triggered in every U.S. recession since 1970.

But Sahm herself doubts a recession is “inevitable.” Speaking before the numbers were released Friday, she said: “If Sahm’s rule were to be triggered, it would join an ever-growing group of indicators, rules of thumb, that are not up to the task.”

Other previously reliable recession indicators that have proven ineffective in the post-pandemic era include:

— A bond market measure with a “dry as dust” label: the “inverted yield curve.”

— The rule of thumb is that two consecutive quarters of decline in economic output constitute a “technical recession.”

On Wednesday, Federal Reserve Chairman Jerome Powell said he was aware of the Sahm Rule and its implications, but noted that other recession signals, such as changes in bond yields, had not materialized in recent years.

“In this pandemic era, so many of the supposed rules have been disregarded,” Powell said at a news conference. “A lot of the accepted wisdom just hasn’t worked, and that’s because the situation is really unusual or unique.”

TO WATCH: Fed Chair Powell holds news conference as first rate cut in four years ‘gets closer’

Powell spoke after Federal Reserve officials kept their key interest rate unchanged but suggested they could cut it as early as their next meeting in September.

Powell also downplayed the impact of Sahm’s Rule, calling it a “statistical regularity.”

“It’s not like an economic rule that says something has to happen,” he said.

For four years, economists have struggled to make sense of an economy that was first shut down by the COVID-19 pandemic, then returned with such force that it revived inflationary pressures that had lain dormant for four decades. When the Federal Reserve moved to tame rising prices by aggressively raising interest rates starting in March 2022, economists almost unanimously predicted that higher borrowing costs would trigger a recession. It never came.

Post-pandemic trends in the U.S. labor market may have at least temporarily weakened the effectiveness of the Sahm Rule.

Unemployment is rising steadily, not so much because companies are cutting jobs but because so many people are flooding into the labor market. Not everyone finds a job right away. The newcomers are dominated by immigrants—many of them came to the country illegally. They are less likely to respond to the Labor Department’s job surveys, so they are not counted as employed.

An inverted yield curve is seen as a signal of a recession because of expectations that a recession will occur when the Fed sharply raises its benchmark interest rate, which it has raised 11 times in 2022 and 2023. An inverted yield curve occurs when the interest rate on short-term Treasury bonds, such as the two-year note, rises above the interest rate on long-term bonds, such as the 10-year Treasury note. The change occurred in July 2022, and yields have been inverted since then, the longest inversion on record.

Typically, long-term bonds have higher yields to compensate investors for tying up their money for a longer period. When short-term bonds start paying higher yields, it’s usually because markets expect the Fed to raise the short-term interest rate to tamp down inflation or cool the economy. Such moves often lead to recessions.

According to Deutsche Bank, an inverted yield curve has preceded each of the last 10 recessions, usually by about one to two years. It gave one false signal in 1967, when it inverted but did not decline.

Why wasn’t everything okay this time?

David Kelly, chief global strategist at JP Morgan Asset Management, says that historically, the yield curve inverts in part because long-term yields fall on expectations that the Federal Reserve will cut interest rates as the economy falls into recession.

However, Kelly said investors expected the Fed to cut rates because of falling inflation, not because of a projected recession.

“The perception of why the Federal Reserve might lower short-term interest rates now is much different than it was in the past, which is why the yield curve is not as dire as it was in previous instances,” Kelly said.

And Tiffany Wilding, an economist and managing director at bond giant PIMCO, says the government’s massive financial aid packages, totaling about $5 trillion in 2020 and 2021, have enriched both consumers and businesses. As a result, they have been able to spend and invest without borrowing as much, cushioning the impact of the Fed’s rate hikes and muting 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 consecutive quarters, a long-standing pattern that almost always accompanies recessions. Then-House Speaker Kevin McCarthy, a California Republican, said the U.S. economy was in a recession that month. He turned out to be wrong.

It’s true that key economic indicators showed that production was falling. But another indicator in the GDP report told a different story: after stripping out volatile items like inventories, government spending and imports, it showed that the underlying economy was still growing at a healthy pace.

Economists worry that last month’s rise in the unemployment rate could herald a broader slowdown. But consumers, especially those with higher incomes, have continued to increase their spending and are likely to continue to do so as long as layoffs remain low.

“I don’t think the U.S. economy is falling out of bed,” said Blerina Uruci, chief U.S. economist for fixed income at T. Rowe Price. “I’m still not in the camp that thinks the U.S. economy is headed for a hard landing.”

Associated Press writer Josh Boak contributed to this article.