Many economists and commentators have been popping champagne corks and toasting the US Federal Reserve for having steered the economy toward a soft landing.
There is just one problem: the plane has not landed yet.
What would a soft landing look like? Inflation would remain at or adequately close to the Fed’s 2% target for a sustained period while employment and economic output would increase at rates low enough not to put upward pressure on prices but also high enough to avoid recession.
Yes, the US economy has slowed considerably and with much less economic hardship than many — including me — feared would occur. In 2021, the economy added an average of 604,000 net new payroll jobs each month. In 2023, average net monthly job gains had fallen to 251,000.
Likewise, consumer price inflation has cooled significantly. Using the Fed’s preferred measure — the personal consumption expenditures (PCE) price index — inflation (on a y-o-y basis) peaked at 7.1% in June 2022 and fell to 2.4% by January. During that period, the unemployment rate never surpassed 4%.
But despite this impressive progress, the economy remains some distance from a soft landing. The labour market is unsustainably hot. In February, employers added 275,000 jobs — around three times as many as one would expect during a soft landing. In 1Q2024, GDP is expected to grow at a pace that, if maintained, would add to inflationary pressure. And as measured by the core PCE price index, monthly inflation in January was higher than in any month since January 2023.
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Beyond any one month’s data, there are other reasons to be concerned that this underlying trend could accelerate. If that happens, inflation could get stuck at a level inconsistent with the Fed’s target, reducing — perhaps even to zero — the number of times the Fed will cut interest rates this year.
Growth expectations for 2024 were improving over last year in response to the Fed’s pivot away from hiking interest rates. Financial conditions eased in 4Q2023 and are looser than a year ago, which could lead to the economy running hot. The pace of monthly job gains did not decelerate last year. In fact, net employment may have trended higher in 4Q2023 and into February, while wage growth has hovered around 4.5% for the past year — well above a level consistent with the Fed’s target for price inflation.
The economic outlook is unusually murky, with different sets of indicators telling different stories. Some signs point to the economy being on the verge of cooling rather than running hot. But those indicators also suggest that a hard landing — a recession — is more likely than a soft landing.
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For example, new orders of capital goods have slowed to a crawl, which suggests a dim outlook for business investment and overall GDP growth. Moreover, other factors are increasing concerns about the outlook for consumer spending. In January, retail sales fell sharply, down 0.8% relative to the previous month, while forecasters expected only a 0.1% drop. Credit-card delinquencies have been rising for all age groups since early 2022 and recently surpassed pre-pandemic levels.
Most importantly, consumer sentiment remains in recessionary territory, likely owing to high price levels and high interest rates. Sentiment is important because recessions are ultimately caused by a loss of confidence in the future. Consumers who are worried about their near-term finances limit their spending. A recessionary psychology takes hold, which leads businesses to cancel vacancies and lay off workers, which in turn further reduces demand.
A soft landing — inflation durably at the Fed’s target and employment and GDP growing at a sustainable pace — is less likely than the economy re-accelerating or mildly contracting. And if a recessionary mindset takes hold, the economy may contract rapidly, because no business wants to be the last to take a conservative posture on spending and headcount. When the unemployment rate rises by half a per cent within one year, it continues to rise into recessionary territory (it is often said to go up in an elevator but come down on an escalator).
Of course, a soft landing is not impossible. The most compelling argument for this outcome is that tightness in the labour market has been driven largely by elevated levels of job vacancies, not by excessive employment. Job openings were 75% higher in March 2022 than in February 2020, but they are currently less than one-third higher than pre-pandemic levels. If high interest rates can lower vacancies without destroying jobs, then the Fed might achieve a soft landing.
The Fed must peer through the murk and assess which direction the economy is heading. At the time of this writing, investors in the bond market expect the first rate cut to occur in June. With the Fed’s policy rate well above the so-called “neutral rate,” this is a reasonable forecast. But if the economy is as strong this spring as it was at the start of this year, the balance of risks will point away from rate cuts.
In other words, keep your champagne corked. — © Project Syndicate, 2024
Michael R. Strain, Director of Economic Policy Studies at the American Enterprise Institute, is the author, most recently, of The American Dream Is Not Dead (But Populism Could Kill It) (Templeton Press, 2020)
