Q3 Economic Update
I hope everyone is enjoying their summer despite the extremely hot days across the country. Summer has seen its fair share of whiplash so far in the markets and Middle East tension along the Strait of Hormuz, producing seesaw headlines for the last few months. We also saw hiring fall well below expectations in June, alongside revisions for April and May, which once again is reigniting fears of stagflation[1].
At first glance, the raw unemployment figure does not immediately signal stagflation. Stagflation is defined by simultaneous high unemployment and high inflation. The unemployment rate doesn’t look too bad. Unemployment ticked down to 4.2% from 4.3% in May[2]. Typically, this would be seen as a good sign for the economy. Although higher than the historically low 3.4% in April 2023, 4.2% is still considered a solid employment figure that is generally consistent with the Federal Reserve’s long-run unemployment rate estimate[3].
However, why stagflation is reoccurring as a concern has more to do with the Labor Force Participation Rate. Relatively speaking, this number fell off a cliff in 2020 with the COVID pandemic but never recovered to its pre-pandemic level. The rate experienced a downward trend since the year 2000, but 2020 was essentially a break in the graph, where it reset to a lower level. Now, after a brief recovery, it is continuing a downward trend[4]. While exiting the labor force could have a positive catalyst, such as having children, retirement, or deciding to be a one-income household, it is often a signal of fatigue in the labor markets when people are unable to get hired for a considerable time. The number likely suggests discouraged workers stopped looking for work entirely. The unemployment rate of 4.2% is a number hiding a cooling labor market.
At the same time, inflation is still well above the Federal Reserve’s 2% target, with a 4.2% year-over-year increase in headline inflation in the most recent report. At the beginning of the year, the expectation was that the Federal Reserve would likely cut the target rate at least once over the year. As of the time I’m writing this, there is roughly 30% probability of a rate increase for July 2026 on the FedWatch Tool[5]. When I look at the historical probability from the FedWatch Tool from January, there was an estimated probability of a cut by July of roughly 88%. Things have clearly changed. The conflict in the Middle East and sticky inflation are making increased rates more of a likelihood as we turn the page into the back half of the year. The Federal Reserve is seeing the conflicting sign of a slowing labor market, although the 4.2% unemployment rate may give them the green light to focus on the inflation problem in the near term. That said, the dual mandate of full employment and price stability may be at odds as we move throughout the year if stagflation becomes a higher possibility.
[1] https://www.wsj.com/economy/jobs/june-jobs-report-unemployment-6c9540b6
[2] https://fred.stlouisfed.org/series/UNRATE
[3]https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20260617.htm#:~:text=%2D%20%2D%20%2D%20%2D%20%2D%201.8.%201.9.,4.3.%204.0.%204.0.%203.8.%20PCE%20inflation.%20Percent.
[4] https://fred.stlouisfed.org/series/CIVPART
[5] https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
