If there was ever a doubt that big-picture, macro issues were not back in vogue, last week helped settle the debate. Between mega-cap earnings results (which were largely met with a lack of investor enthusiasm), the Federal Reserve's decision to leave rates unchanged (which didn't reveal much more than what we already know about officials' views), and the July jobs report (which caused recession fears to spike), there was no shortage of news that drove an incredibly volatile week for stocks. In the span of three days, the S&P 500 had its best day since this past February and the second-worst decline of the year. Liz Ann certainly picked an interesting time to be on vacation!

There was no major inflation news last week, given the Fed's preferred inflation gauge—the personal consumption expenditures (PCE) Price Index—was updated back on July 26th. Revisiting the results from that June data helps paint the picture for this report.

As shown in the chart below, it's clear that the disinflation trend has resumed. The three-month annualized change in core PCE (yellow line) has downshifted sharply after that brief, scary bump in the first quarter of the year. That should start to weigh on the six-month annualized change (green line) soon and keep the year-over-year change (blue line) in a downtrend. We're not back to the Fed's 2% target, but officials (and notably, Chair Powell) have mentioned several times that they'd like to cut rates before getting there.

Bringing the Fed's other mandate—employment—into the picture, it's clear that the labor market is starting to have an increasingly negative reaction to higher rates. As shown in the chart below, the employment component in the ISM Manufacturing Index (another disappointing economic data release last week) slipped in July to its lowest since June 2020. Fortunately, that was accompanied by only a slight uptick in the prices paid component.

Key to keep in mind is that in this unique cycle, survey-based data like the ISM indexes have been harder to rely on when it comes to the direction of the economy. Case in point: Even though the above chart shows a marked decline in manufacturing employment for July, the Bureau of Labor Statistics' (BLS) July jobs report showed a gain of 1,000 manufacturing jobs, as well as a gain of 25,000 construction jobs.

That said, though, it's getting harder to deny some of the more traditional recession warnings in the labor data. At first glance, July's jobs report was not bad: 114,000 jobs added, an unemployment rate at 4.3%, and the highest prime-age labor force participation rate since March 2001–not to mention Hurricane Beryl's potential impact on payroll growth (there was a huge spike in individuals not at work due to weather). However, the true weather effect is hard to measure, and trend is much more important at this stage of the cycle.

As shown in the chart below, the unemployment rate has been creeping higher over the past year as year-over-year growth in average hourly earnings has been slowing. Both trends tend to be consistent with a recession already (or shortly) underway.

The rise in the unemployment rate in July got the most attention; and rightfully so, given its larger-than-expected increase from 4.1% to 4.3%. Even more notable is how far above its longer-term average it now is. As shown in the chart below, the spread between the current rate and its rolling three-year average is now 0.5 percentage points. Going back to the mid-1950s, we have never seen a spread that wide without the economy already being in a recession. As we've mentioned several times, this is a unique cycle, so we shouldn't be too dogmatic when it comes to one single indicator, but we do think this is a worrisome trend worth monitoring.

The downside is that the cracks under the labor market's surface we have been monitoring are widening. From an inflation perspective, the upside is that it's getting harder to see where upward pressure on prices is going to come from. An increasingly soft labor market is consistent with slower wage growth, slower spending, and disinflation.

We're continuing to see that via metrics like the Employment Cost Index (ECI). As shown in the chart below, the year-over-year change in the ECI has rolled over and slowed to just slightly above 4% through the second quarter of this year. That's elevated relative to the pre-pandemic expansion, but it's getting closer to the long-term average.

The easing in compensation costs is consistent with a marked slowdown in unit labor cost growth, which was the standout data release last week. As shown in the chart below, the year-over-year trends in productivity and unit labor costs continued to move in the right direction through the second quarter. For the latter, annual growth was the slowest since the third quarter of 2019. This is perhaps the clearest way to see that the economy is not facing a wage-price inflation spiral like it did in the 1970s and 1980s.

All else equal, the fact that the rate of inflation is outpacing unit labor cost growth is good news for companies and their profit margins. However, as the current earnings season has revealed, there are more than enough cases of companies losing their pricing power; and for those that have been able to maintain it, the ability to do so might not last much longer if the labor market continues to deteriorate.

The July jobs report was met with a sharp decline in risk assets and bond yields, as well as a chorus of Fed watchers saying the central bank was wrong to hold at the July meeting. As such, the market has started pricing in larger rate cuts (50 basis points) for upcoming meetings. That might raise suspicion that the economy is deteriorating quickly, but there is a difference between the Fed dialing back its restrictiveness at an aggressive pace and slashing rates to try and save a faltering economy. It's entirely possible that the former scenario plays out; what might be difficult is officials having to communicate that in a reassuring way.

As such, we expect volatility to remain elevated in both the market and economy over the next several months. Expectations for Fed rate cuts will jump around swiftly given the slew of crucial data until the September meeting; as well as the Kansas City Fed's upcoming annual Jackson Hole summit. Assuming the current inflation and labor trends continue to hold, though, the economy's message to the Fed is clear: It's time to start getting much less restrictive.