Will Fed policy trigger a US recession?

Episode Summary

Executive Summary: The episode examines whether the Fed is behind the curve as labor data weaken and recession fears rise. Claudia Somm says the SOM rule’s trigger is warning-like but not proof of recession, while Bill Dudley sees recession odds at 50-60% and urges faster rate cuts. Rob Kaplan agrees cuts should begin soon, but frames any delay as tactical, not strategic, and warns against overreacting to one jobs report.

Main Topics: SOM rule and what the trigger means (Priority: 5/5): Claudia Somm explains how her recession indicator was built from historical unemployment patterns to identify recessions early and reliably, but emphasizes it is not a forecast and can be distorted by labor-supply changes. Labor market softening versus recession (Priority: 5/5): All three speakers discuss weaker hiring, rising unemployment, and declining quits, but differ on whether these signals point to an imminent recession or a manageable slowdown. Fed policy timing and rate cuts (Priority: 5/5): The conversation centers on whether the Fed has waited too long to cut rates. Somm argues the Fed needs to move to avoid an unnecessary downturn; Dudley says the Fed is behind the curve; Kaplan supports starting cuts in September. Recession risk and feedback loops (Priority: 4/5): Dudley stresses the classic recession dynamic: once unemployment rises past a tipping point, household and business confidence weaken, feeding further layoffs, weaker spending, and investment pullbacks. Interpreting noisy data and revisions (Priority: 4/5): The speakers caution against overreacting to one monthly jobs report, noting that labor data can be volatile, revised later, and affected by supply-side shifts like immigration and participation changes. Soft landing versus policy error (Priority: 4/5): The discussion contrasts the Fed’s soft-landing goal with the risk that keeping policy too tight could create an avoidable recession, especially given inflation’s progress and the room to cut rates.

Key Arguments: The SOM rule is designed as a reliable recession trigger, not a forecast, and it can be fooled by unusual labor-supply shifts. A rise in unemployment can reflect either weakening labor demand (recessionary) or a surge in labor supply (less ominous), so context matters. Hiring and quits rates are weakening, which suggests some real softening in labor demand even if layoffs remain low. The Fed’s high policy rate has likely contributed to slowing growth, so delaying cuts further could create an avoidable recession. Dudley argues that once unemployment crosses a threshold, history shows a strong self-reinforcing downturn can follow. Dudley assigns recession odds of 50-60% over the next 12 months, while Somm sees higher-than-normal but still not dominant risk. Kaplan thinks the labor market is softening but not collapsing, and he expects the Fed to begin cutting in September. Kaplan distinguishes between tactical timing mistakes and strategic mistakes, arguing the Fed can still correct course if it acts soon. All three caution investors not to anchor on a single data point; broader structural and real-time business signals matter too.

Data Points: SOM rule trigger: 0.53 percentage point increase in unemployment rate - Claudia Somm says this rise triggered the SOM recession indicator in July 2024. Fed funds rate: Over 5% for about a year - Somm cites this as part of the policy restraint slowing the economy. Goldman Sachs Research rate-cut path: 25 bps in September, November, and December - The host cites the firm’s baseline forecast for Fed easing. 12-month recession odds: 20% - Goldman Sachs Research’s base-case recession probability. 12-month recession odds if August payrolls are benign: 15% - Goldman Sachs Research’s lower-risk scenario. Bill Dudley recession odds: 50-60% - Dudley’s estimate of recession probability over the next 12 months. Historical unemployment move after SOM trigger: Next stop is 1.9 percentage points - Dudley says history shows a large additional jump often follows once the threshold is crossed. Hiring rate comparison: Back to 2014 levels - Somm notes hiring rates are unusually weak relative to the current unemployment rate. Unemployment context: Low but rising - Somm repeatedly emphasizes that the unemployment rate is still low even as it trends upward. Interview dates: August 14, August 15, and August 19, 2024 - The three expert interviews were recorded on these dates.

Pivotal Quotes: "If there is a recession in the next year or so, it is a huge unforced policy error." — Claudia Somm: Somm argues the Fed should cut sooner rather than risk creating an avoidable downturn. "I probably put it at 50 to 60 percent over the next 12 months." — Bill Dudley: Dudley gives his recession probability estimate after discussing the SOM trigger and labor-market weakness. "If they are behind, they're not behind by more than a meeting or two." — Rob Kaplan: Kaplan downplays the idea of a major Fed mistake, framing the issue as timing rather than strategy.

Implications: The Fed likely has room to cut without reigniting inflation, but waiting too long could turn a soft landing into a mild recession. Investors should watch labor trends, not just one jobs print, and focus on broader structural signals alongside Fed communication.