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Is the US Economy Headed for a Soft Landing?

by internationalbanker

By Cary Springfield, International Banker


It is the U.S. Federal Reserve’s (the Fed’s) biggest conundrum. How can inflation be reined in without sending the US economy into a potentially deep and painful recession? And with price growth still running hot, that conundrum is yet to be solved. Worse still, the looming threat of a banking crisis and a labour market running hotter than ideal have made solving that equation even tougher for policymakers than ever before. But with more recent data suggesting that the pace of accelerating prices is slowing and the Fed abating the pace of interest-rate hikes—albeit as a seemingly temporary measure—there remains hope that an economic soft landing can be achieved in the end.

2022 saw the US economy undergo a total of seven rate increases, four of which were hefty 75-basis-point hikes as the Fed and other leading central banks struggled to contain runaway prices across much of the world. Rates began the year at the lower bound of 0-0.25 percent and ended at 4.25-4.5 percent, marking a period of aggressive monetary tightening that helped pull the inflation rate down from a June peak of 9.1 percent—a mighty 40-year high—to 6 percent in February. As such, the job of bringing inflation down to near the Fed’s explicit target of 2 percent is far from complete, as analysts remain broadly undecided over how much longer interest rates will need to be raised to achieve the target—and whether those rate hikes will induce a pronounced economic contraction alongside a spike in unemployment.

And therein lies the Fed’s biggest challenge: ensuring that the tradeoff of lower growth and higher joblessness in exchange for low, stable inflation is not unnecessarily exacerbated. And truth be told, much uncertainty continues to pervade the market over just how this slowdown will ultimately transpire, and thus the Fed’s next moves remain up for much debate. “In our view, the persistence of both high inflation, strong consumer demand, and very high job openings suggest that the Fed needs to slow the economy enough to open a modest amount of slack,” economists Wendy Edelberg, Lucas Fox and Isabel Leigh of the Brookings Institute’s Hamilton Project economic policy initiative wrote on March 23. “Not doing so risks inflation expectations rising to such a persistent degree that significant economic weakness would be necessary to bring inflation down. This will require the unemployment rate being temporarily above the noncyclical rate—which is itself somewhat higher than the current unemployment rate.”

Indeed, concerns are growing over the tightness of the US labour market, with wage growth particularly failing to cool down as much as policymakers had hoped. And with recent initial jobless-claims data further underscoring this market tightness, the Fed will undoubtedly feel pressured to continue raising rates until the hiring rate slows. “Labor market data came in stronger than expected,” Fed Chair Jerome Powell acknowledged following the central bank’s March 22 meeting, adding that while upward pressure on wage inflation is likely to slow over time, there are not enough clear indications that inflation driven by the labour market is slowing down enough.

“The big concern is still that the number of people filing for unemployment, although it had a couple [of] small gains, just turned back down again. I think wages will remain sticky as there are still a lot of job openings for lower-paid workers which will make it difficult to scale anything back,” Ron Hetrick, a senior labour economist at labour market analytics firm Lightcast, explained to CNBC on March 23, adding that wage-growth percentages remain well above historical averages. “If the goal is to see those percentages in line with more recent history…there is a lot of work to be done.”

But if this “work” involves further rate hikes, expectations of a quick-fix solution will have to be further tempered as fears grow of a full-scale US banking crisis materialising this year. As if the balancing act between containing inflation and avoiding a recession and high unemployment was not tricky enough, the collapses of SVB (Silicon Valley Bank) and other important US lenders have thrown a spanner in the works as far as the Fed’s task of engineering a soft landing is concerned. Indeed, the latest monthly Bloomberg survey of economists published on March 28 showed that the probability of a recession in the next 12 months stood at 65 percent, up from 60 percent, following the bank closures.

Such growing concerns go a long way towards explaining why the Fed chose to raise rates by only 25 basis points at its March 22 meeting. The process of getting inflation back down to 2 percent “has a long way to go and is likely to be bumpy,” Powell admitted following the March rate-setting meeting, indicating that recent banking-sector woes were hugely influential in moderating rate hikes. “It’s too early to say, really, whether these events have had much of an effect…. I do still think though that there’s, there’s a pathway to [a soft landing]. I think that pathway still exists, and, you know, we’re certainly trying to find it.”

But while this modest move may enthuse those doves keen to see the end of this contractionary monetary cycle sooner rather than later, the justification for doing so seems squarely focused on alleviating the tighter credit environment likely to unfold from the banking failures. As such, March’s more accommodative monetary tightening is almost certainly a temporary measure to support credit markets, with further rate hikes this year still in the offing.

Powell also confirmed that “rate cuts are not in our base case” during 2023, while the Fed emphasised that some additional policy firming may be appropriate “in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time”. This decidedly hawkish tone certainly seemed to spook the markets, with the Dow Jones Industrial Average (DJIA) benchmark stock index shedding around 500 points following Powell’s press conference as fears continued to grow that a hard landing—prompted by both further rate hikes and prospects of banks turning off the credit taps—could well be unavoidable. “History tells us that durable turning points for markets tend to arrive once investors begin to anticipate interest rate cuts and a trough in economic activity and corporate earnings, but the Fed’s actions and analysis of the economy suggest these conditions are not yet fully in place,” Swiss bank UBS noted on March 23.

By April 3, the market was pricing in a likely 25-basis-point (bps) rise when the FOMC (Federal Open Market Committee) meets next on May 4, with the CME Group’s 30-Day Fed Funds Futures price tool showing a modest 59-41 probability in favour of raising rates rather than keeping them unchanged. This further underscores that additional monetary tightening is coming, albeit in perhaps more modest 25-bps increments, which may be maintained until the Fed is sure that contagion risks from the recent banking stress have been adequately contained. “The US banking system is sound and resilient,” the FOMC recently said in a reassuring statement. “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain. The Committee remains highly attentive to inflation risks.”

So, can a soft landing be achieved in the end? “As long as inflation expectations, in the long run, look like they’re well-anchored, I think the Fed can afford to be patient” and keep raising rates without the sudden need to pull back to avoid a recession, said Joel Prakken, chief US economist at S&P Global Market Intelligence, on March 6. The Congressional Budget Office (CBO), meanwhile, claimed it sees inflation gradually slowing this year “as pressures ease from factors that, since mid-2020, have caused demand to grow more rapidly than supply”. The US federal agency also stated it expects output to “stagnate” and unemployment to rise as further rate hikes weigh on growth. “After that, inflation slowly returns to the Federal Reserve’s long-run goal of 2 percent, and output grows at a more robust pace as interest rates decrease.”


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