Last Friday’s weaker-than-expected jobs report has sparked a robust debate about whether the US economy is sliding into recession or whether the rise in the unemployment rate in July was due to a continuing post-pandemic normalisation of the labour market.

Whichever camp you’re in, the right move for the US Federal Reserve (Fed) is to act with urgency, cutting its policy rate a percentage point to 4.25%-4.5% by the end of the year in the name of risk management.

It’s a level of easing that the Fed is likely to undertake even if the rise in unemployment ends up being somewhat benign since we no longer need such restrictive rates to tame inflation.

It makes sense to frontload those rate cuts rather than run the risk of being too slow to act to forestall worse economic outcomes.

If we really are heading into recession, there’s not much disagreement on what the Fed should do: Cut interest rates a lot and fast. That’s where market pricing has shifted after a rocky week of economic data. Interest rate futures suggest the Fed will cut its policy rate by over 200 basis points by the end of 2025, taking the fed funds rate down near 3%.

This seems reasonable based on what we’ve seen in prior recessions.

It’s the second scenario that is more challenging. The jobless rate has climbed this year from 3.7% to 4.3%, but the percentage of people between the ages of 25 and 54 who are employed has also risen, from 80.4% to 80.9%. That’s an unusual dynamic with the unemployment rate reflecting, in part, rising labour force participation.

It’s possible that the explanation of a gradual normalisation is the correct one, that there’s little risk of a rapid increase in unemployment, and that the Fed has time to be patient. But putting all of one’s eggs in that basket is risky.

The rate of layoffs is currently low, but waiting for job cuts to increase means waiting until it’s too late to avoid a recession.

During the financial crisis, for instance, layoffs didn’t start to spike until the middle of 2008 once a recession was well underway. The hiring rate has already slumped to levels that suggest employers feel no compulsion to add to their payrolls.

The rate of hiring has fallen below the pre-pandemic average. In general, it’s best not to overthink the unemployment rate.

Inflection points in the economy are messy and uncertain by nature, and leaning too much into optimistic scenarios can cause severe policy errors.

Former Fed chair Ben Bernanke gave his “subprime is contained” speech in May 2007 when the housing market was already in the process of collapsing.

 - Bloomberg