By Alexander Jones, International Banker
It has been perhaps the most significant economic debate over the last year. The question of whether the US economy, at the hands of the Federal Reserve System (the Fed), can engineer a “soft” landing—and avoid a “hard” landing or no landing at all—has left economists guessing for several months now. With the annual inflation rate continuing its steady decline to below 4 percent in recent months from its highest levels in 40 years in the summer of 2022 and with interest rates seemingly having peaked, signs increasingly point to a recession being avoided and, thus, a soft landing being realised. Nonetheless, with key risks to the downside persisting, more painful outcomes for businesses and households are still not entirely out of the question.
The Fed’s rate-setting Federal Open Market Committee (FOMC) announced on January 31 that it had left rates unchanged in the 5.25–5.50-percent range, a nearly 23-year high, thereby strongly suggesting that its aggressive rate-tightening cycle, which began in March 2022, had finally ended. But with price growth still comfortably above the Fed’s 2-percent long-run target—annual inflation increased in December to 3.4 percent from 3.1 percent a month earlier—a rate cut is still not on the horizon. “The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent,” the FOMC announced in a statement.
Rates being stable for the fourth consecutive FOMC meeting not only suggests that further rate hikes are less likely but also crucially indicates that a soft landing may be achieved—that is, that inflation can be reduced to target levels without sending the economy into recession, defined as two consecutive quarters of contraction in gross domestic product (GDP), or triggering excessive joblessness. “I would say that a soft landing is when we increase interest rates, and we manage to decrease inflation, but without causing unemployment to go up drastically and GDP growth to go negative,” Paulina Restrepo-Echavarria, an economic policy advisor in the Federal Reserve Bank of St. Louis’s Research Division, explained in October. “And a hard landing would be yes, we increase interest rates, and we decrease inflation, but at the cost of a recession and high unemployment.”
According to a poll of economists conducted by the National Association for Business Economics (NABE) published on January 22, a whopping 91 percent of respondents gave a 50-percent probability or less of the US entering a recession over the next 12 months. This was significantly higher than the 79 percent of economists who held such a view in NABE’s October edition of the survey and a significant reversal from the 53 percent who, in January 2023, assigned a greater than 50 percent likelihood that the US would enter a recession over the ensuing 12 months, at a time when the Fed was sharply raising rates to combat high inflation at almost 6.5 percent.
Times have undoubtedly changed since then, with inflation much closer to the Fed’s target now than a year ago. And with quarterly growth in gross domestic product hitting 4.9 percent and 3.3 percent in last year’s third and fourth quarters, respectively, talk of a recession has been allayed for now. “In many ways, we already have a soft landing,” a Columbia Business School economics professor, Brett House, told CNBC before the FOMC’s late-January meeting. “The Fed has threaded the needle of the economy very artfully with a kind of ‘Goldilocks’ scenario.”
Perhaps somewhat illusory are the true drivers of the US’ recent GDP acceleration, however—chiefly, the exorbitant government spending that has risen dramatically in recent years. Having doled out trillions of dollars in stimulus to support businesses, households and workers during the pandemic, the government’s taps have continued to mostly stay on until now, with President Joe Biden’s administration spending heavily, widening the federal deficit from around 5.3 percent of total GDP in 2022 to 6.2 percent last year. “As the economy recovered, the US just poured more kerosene onto the fire,” Kristin Forbes, an economist at the MIT (Massachusetts Institute of Technology) Sloan School of Management and a former Bank of England (BoE) official, recently told the New York Times, noting that as a share of GDP, US government spending is higher than in many other advanced economies.
The US’ recent growth uptick has also been supported by a strong job market and buoyant consumer spending, raising the prospect of elevated inflation persisting over the coming months—and crucially remaining above the Fed’s elusive 2-percent target. While US core-goods inflation—excluding the typically more volatile food and fuel components from the calculations—was roughly flat throughout 2023, inflation in the services sector has remained stickier in recent months.
And with the US adding 353,000 jobs in January, almost double what was initially estimated by analysts, inflation expectations have nudged higher since early February, such that the March forecast for the first rate cut initially pencilled in by the market has since been scrapped for two or three months down the line. “We’re slowly coming into line with the Fed,” Sonal Desai, chief investment officer for Franklin Templeton Fixed Income, told the Financial Times. “There was a sense in December that the market could push the Fed to cut sooner. But the data hasn’t co-operated with the market. The data has not been weak enough to pressure the Fed to cut early.”
Meanwhile, J.P. Morgan predicted the US labour market would first have to cool before inflation could sufficiently ease towards target levels. “In 2024, while the unwinding of supply chain shocks could deliver further disinflation, we think the ‘final mile’ of getting inflation down will require a softer labor market,” Michael Feroli, chief US economist at J.P. Morgan, said in early February. “We are already seeing wage inflation slow, and we think the labor market should soften over time as the economy is impacted by higher interest rates. This should allow core services prices to moderate, working to bring broader inflation aggregates closer to target.”
Should Feroli’s forecast materialise, one might reasonably expect the Fed to begin cutting rates promptly to maintain a positive growth environment, prevent excessive job losses and ultimately achieve that elusive soft landing. That said, key downside risks remain that could send prices higher, particularly across the energy complex. “After a strong run throughout much of 2021 and 2022, food price inflation settled down to a more moderate trend of 0.2 percent monthly gains in 2023, and we look for similarly unexciting increases moving forward,” Feroli noted. “Swings in energy could be important, but we believe that any upcoming big changes would be more likely related to factors such as geopolitical events.”
Indeed, the International Monetary Fund (IMF) has been particularly watchful over how geopolitical tensions in the Middle East and Ukraine might push commodity prices higher and disrupt supply chains, thus putting upward pressure on prices. “Staying on the path to a soft landing will not be easy,” IMF chief economist Pierre-Olivier Gourinchas said in late January, adding that commodity price spikes from geopolitical shocks, including the conflict in the Red Sea that continues to restrict key shipping routes, could prolong central banks’ monetary-tightening actions. That said, Gourinchas did acknowledge that the broader economic impacts of such events appear “relatively limited” at present. “It doesn’t seem to represent, as of now, a major source of potentially reigniting supply-side inflation.”
But with December’s annual inflation reading 0.3 percent higher than November’s, a distinct possibility remains that prices will stay outside the Fed’s level of acceptability or even begin heading northwards again. And should they fail to resume their approach towards Fed target levels, the possibility of a “no-landing” scenario—in which both growth and inflation continue indefinitely above trend despite rates remaining elevated—becomes greater. Borrowing and investment costs will thus remain heightened for households and businesses, respectively, as the economy continues to overheat.
Such a scenario seems much less likely to transpire than a soft landing, however, as inflation has largely continued its long-term descending trend in recent months—December excluded—and the US’ GDP growth trajectory is expected to remain positive throughout 2024. Indeed, thanks largely to strong fiscal support and consumer spending, the IMF’s January edition of its “World Economic Outlook” saw the United States receive one of the biggest upgrades to its growth prospects, with 2024 GDP projected to expand by 2.1 percent (against the 1.5 percent forecast in October) and by 1.7 percent in 2025.
Therefore, most analysts expect the Fed to start trimming rates from the second quarter onwards, including Calvin Tse, the head of Americas macro strategy at BNP Paribas, who forecasted rates first being lowered at the FOMC’s May 1 meeting before 25 basis-point cuts are delivered at all of the five remaining FOMC meetings scheduled this year, in line with the expected dramatic slowdown in inflation. “If the Fed doesn’t cut rates, and inflation comes down as much as we think it will, that would mean policy was becoming more restrictive,” Tse explained to the Financial Times on February 6. “And Powell has already said that policy is sufficiently restrictive.”