Charted: The link between unemployment and recessions

The U.S. labor market is having a strong start to 2023, adding 504,000 nonfarm payrolls in January, and 311,000 in February.

Both figures surpassed analyst expectations by a wide margin, and in January, the unemployment rate hit a 53-year low of 3.4%. With the recent release of February’s numbers, unemployment is now reported at a slightly higher 3.6%.

A low unemployment rate is a classic sign of a strong economy. However, as this visualization shows, unemployment often reaches a cyclical low point right before a recession materializes.

In an interview regarding the January jobs data, U.S. Treasury Secretary Janet Yellen made a bold statement: "You don’t have a recession when you have 500,000 jobs and the lowest unemployment rate in more than 50 years."

While there’s nothing wrong with this assessment, the trend we’ve highlighted suggests that Yellen may need to backtrack in the near future. So why do recessions tend to begin after unemployment bottoms out?

The economic cycle refers to the economy’s natural tendency to fluctuate between periods of growth and recession.

This can be thought of similarly to the four seasons in a year. An economy expands (spring), reaches a peak (summer), begins to contract (fall), then hits a trough (winter).

With this in mind, it’s reasonable to assume that a cyclical low in the unemployment rate (peak employment) is simply a sign that the economy has reached a high point.

During periods of low unemployment, employers may have a harder time finding workers. This forces them to offer higher wages, which can contribute to inflation.

For context, consider the labor shortage that emerged following the COVID-19 pandemic. We can see that U.S. wage growth (represented by a three-month moving average) has climbed substantially, and has held above 6% since March 2022.

The Federal Reserve, whose mandate is to ensure price stability, will take measures to prevent inflation from climbing too far. In practice, this involves raising interest rates, which makes borrowing more expensive and dampens economic activity. Companies are less likely to expand, reducing investment and cutting jobs. Consumers, on the other hand, reduce the amount of large purchases they make.

Because of these reactions, some believe that aggressive rate hikes by the Fed can either cause a recession, or make them worse. This is supported by recent research, which found that since 1950, central banks have been unable to slow inflation without a recession occurring shortly after.

The Fed has raised interest rates at an unprecedented pace since March 2022 to combat high inflation.

More recently, Fed Chairman Jerome Powell warned that interest rates could be raised even higher than originally expected if inflation continues above target. Senator Elizabeth Warren expressed concern that this would cost Americans their jobs, and ultimately, cause a recession.

Powell remains committed to bringing down inflation, but with the recent failures of Silicon Valley Bank and Signature Bank, some analysts believe there could be a pause coming in interest rate hikes.

Editor’s note: just after publication of this article, it was confirmed that U.S. interest rates were hiked by 25 basis points (bps) by the Federal Reserve.