Low Unemployment. Good or Bad?

by Sean Tweedie | January 31, 2020

Last month we touched on the global growth outlook for 2020. We were beginning to see the “Green Shoots” of growth start to emerge in the data prints. This month we discuss how strong global growth can impact unemployment and the correlation between low unemployment and the likelihood of a recession. Our view has further been supported by the latest data on global manufacturing activity released this month. In the U.S. the New York Fed Manufacturing PMI beat expectations while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months.

Purchasing Managers Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and services sector and is used to determine whether market conditions, as viewed by purchasing managers, are expanding, remaining unchanged or declining. Similarly, manufacturing data out of Europe and the U.K was strong, with the German ZEW index having surged in January to its highest levels since July 2015.

The U.K business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. One threat (albeit potentially short term) to the budding global economic recovery has been the outbreak of coronavirus.

Outbreaks can affect the economy in two ways. Firstly, they can reduce the demand by curtailing spending on travel, entertainment and any other activity that involves people being near one another. Secondly, they can reduce supply by causing people to avoid going to work. The second is the least likely to occur. Stronger global growth should continue to support the labor market and reduce unemployment. The unemployment rate in the OECD currently stands at 5.1%, below the low of 2007, and in the U.S. the unemployment rate has dropped to a 50-year low. The decline in unemployment following the financial crisis was certainly a welcome development, yet there may be a more sinister result of a very tight labor market. Historically, the likelihood of a recession has risen when unemployment levels are very low. There are three channels of thought that are said to underpin this correlation, and we attempt to make sense of each in turn. Firstly, low unemployment as a consequence of a strong economy may promote risk taking.

While risk taking is essential for an economy, too much of it can lead to imbalances being formed and subsequent downturns. For example, in Australia, New Zealand, Canada and Scandinavian economies, low interest rates coupled with strong economic growth has stoked a debt-fuelled housing bubble. Easier conditions in these economies have led to a massive uptake in mortgages. Global government bond yields are lower today than they were shortly after the financial crisis ended. Many investors argue that there is not much room for bond yields to rise from current levels because asset values would plunge, and debt burdens would become unsustainable, leading to economic distress. See Figure 1.

Profit margins usually peak a few years before the onset of a recession. This has led some to speculate that faster wage growth which stems from a tighter labour market (less unemployment) is the reason for supressed profit margins and that this could usher in a recession by curbing companies’ willingness to hire workers and invest in capital. This theory does not hold up. Surveys on business sentiment clearly show how capital spending intentions are positively correlated with plans to raise wages. See Figure 2.

A reason for this is that rising wages make automation more attractive and by definition that requires more capital spending. The reason for profit margins usually peaking before a recession, is that unit labour costs rise when there is less unemployment, and this leads to an increase in inflation. In order to prevent the economy from overheating, Central Banks raise interest rates, and this in turn affects profit margins. This underpins the third channel of thought being that as the labour market tightens and wage growth accelerates, companies will pass on the higher costs of labour to their customers and this raises inflation. Central Banks raise interest rates in response to higher inflation which very often puts a floor under growth and can lead to a recessionary environment.


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