Hopes for a US ‘soft landing’ grow, but risks remain
For the last 18 months or so, central bankers in the developed world have tightened monetary policy in a bid to slow economic growth and ultimately bring down inflation, which surged in the wake of the pandemic. Rightly or wrongly, this process has been likened to a pilot landing an aircraft. Extending the analogy gives rise to different economic scenarios: a so-called ‘hard landing’ sees central bankers tighten to an extent that the economy slips into a recession, whereas a so-called ‘soft landing’ occurs when interest rates are raised to a degree which causes inflation to fall back towards target, but without the economy experiencing a contraction in activity in the process.
Engineering an economic ‘soft landing’ is tough at the best of times. Unlike a pilot who can accurately monitor and adjust a plane’s altitude and velocity in real time, it takes weeks to collate accurate economic data, and changes in interest rates impact the economy with long and variable lags. The laws of physics dictate that, adjusting for weather conditions, a tweak of the plane’s controls will have a predicable effect on the aircraft’s speed and trajectory. However, structural changes in an economy can mean that both the so-called neutral interest rate (i.e., the rate at which monetary policy is neither contractionary or expansionary) and the speed with which interest rate changes impact the economy can vary over time.
Given these considerations, it is not surprising that ‘soft landings’ are relatively rare. Precise definitions vary, and in some instances the role of monetary tightening in causing a subsequent recession is open to debate (for example, the pandemic-related recession of 2020 was primarily the result of lockdowns rather than the 2015-19 rate hike cycle). However, in the US, of the 11 interest rate hike cycles that we have seen since 1961, only three did not culminate in a contraction in GDP, namely those of 1965-66, 1983-84 and 1993-19951. The latter is widely seen as the perfect ‘soft landing’. Back then, the US Federal Reserve (the Fed), under Chairman Alan Greenspan raised interest rates from 3% to 6% between February 1994 and February 1995, ushering in a deceleration in core inflation (i.e., excluding food and energy) during the following years without pushing the economy into recession2.
Soft landing ahead?
What are the prospects of a ‘soft landing’ for the US economy during the current cycle?
At the beginning of the year, there was a widespread expectation that the US economy would enter a recession at some point in 2023 as a result of the Fed’s steep interest rate hikes. However, the combination of resilient GDP growth and slowing inflation has raised hopes for a ‘soft landing’ in recent weeks. Although the Fed has embarked on its most aggressive monetary tightening in decades (the policy interest rate has risen 525 basis points since March 20223), real GDP expanded at an annualised rate of 2.1% in the second quarter, following a 2.0% rise in Q14. Meanwhile, annual consumer price inflation has slowed from a peak of nearly 9% in June 2022 to just above 3% in July5.
To be sure, much of the slowdown in inflation has not been due to Fed policy, but rather the result of favourable base effects and a pull-back in energy prices6. In addition, prices for some consumer durables, notably motor vehicles, are also now seeing annual price declines7, as global supply chains have normalised following the pandemic-related disruption and household spending patterns have shifted towards services and leisure activities. In contrast, measures of core services inflation, where price pressures are more closely linked to the strength of the domestic economy and growth in labour costs, have been stickier. Fed Chair Jerome Powell has repeatedly highlighted a measure of core services inflation excluding shelter (or housing costs), and while this has moderated somewhat, it still remains too high for the Fed’s liking8.
As the provision of services is more labour intensive than that of goods, the Fed sees the outlook for this component of inflation as closely tied to trends in labour costs. In this regard, signs of a cooling in the labour market bodes well for the service sector disinflation the Fed is looking for. Hiring in the economy has slowed (during the three months to August some 150,000 non-farm jobs were created per month, down from 430,000 per during the same period a year earlier9) and the unemployment rate has edged up to a 16-month high of 3.8% as workers have re-entered the workforce10.
Wages and inflation
Moreover, survey data suggests that widespread job losses might not be needed to bring down wage growth (currently running at an annual rate of 5.7% according to the Atlanta Fed wage tracker11) to a pace that the Fed is more comfortable with. While the labour market is still historically tight, with 1.51 job vacancies for every unemployed person, the number of openings has fallen markedly, to its lowest level in nearly 2½ years in July12. Moreover, the so-called quits rate (the proportion of workers leaving their job voluntarily, invariably to a better paid role) has dropped sharply, from a historic high of 3.0 during the spring of last year to 2.3 in July, in line with pre-pandemic levels13. This could be indicative of workers becoming less confident regarding their work situation and is important because, historically, falls in the quit rate have ushered in a deceleration in wage growth, with a lag14.
New research from the Cleveland Fed has also played down the role of labour market tightness in driving wage growth, concluding that the post pandemic surge in compensation has largely been a lagged response to higher consumer price inflation15. Fed Chair Powell has previously suggested that excess demand for workers has resulted in levels of wage growth inconsistent with the 2% inflation target16. However, economists at the Cleveland Fed suggest recent strong wage growth is the result of increases to compensate for higher living costs, rather than imbalances in the labour market per se. If this is the case (and recent data is somewhat supportive of this view), then the recent decline in headline CPI inflation should naturally lead to a slowdown in wage growth, and thereby reduce the risk of a 1970s-style ‘wage-price’ spiral.
Improved productivity could also mitigate the impact of higher wages on inflation pressures. Labour productivity growth rose to a 3-year high of 3.7% annualised in the second quarter, with the result that unit labour cost growth rose just 1.6% over the same period (a pace that would be consistent with the Fed’s 2% inflation target)17. The data is volatile, and it is far from certain that these favourable trends will continue. However, technological developments such as artificial intelligence do hold out the prospect of a sustained upswing in productivity growth (see our commentary of August 202318).
All of this suggest that the Fed might not need to clamp down on wage growth by overseeing a recession that leads to a significant increase in unemployment. Indeed, although staff economists at the Fed had earlier projected that a recession would start this year, the minutes of the July policy meeting show that this is no longer the case19.
Nevertheless, several factors suggest that a recession could still be on the cards. Although both inflation and wage growth are moderating, the Fed is keen to avoid a repeat of the policy mistakes of the 1970s, and will be wary of cutting interest rates too soon and allowing inflation to re-accelerate. JP Morgan notes that previous soft-landing episodes saw rapid and substantial rate cuts during the year following the Fed’s last rate hike, which in turn had the effect of supporting economic activity20. This time around, swift rate cuts might be less likely given the tightness of the labour market. Indeed, a ‘structural’ increase in inflation resulting from demographic shifts, the green transition and deglobalisation (see our commentary of February 202321) might mean that the monetary authorities need to bear down more aggressively on ‘cyclical’ inflation pressures going forward.
The longer that a restrictive monetary policy stance is kept in place, the greater the toll it will take on households and businesses, and the greater the risk that something will eventually ‘break’. Fiscal policy has no doubt been supportive of growth recently. However, the excess savings accumulated by households during the pandemic are running out22, and student loan repayments are due to restart later this year (see our commentary of June 202323). Regional banks remain under pressure, while higher bond yields and tightening lending standards are likely to result in an increase in corporate defaults. What’s more, forward-looking indicators, such as the yield curve24, the Conference Board’s leading economic index (LEI)25 and trends in temporary jobs26 continue to indicate an elevated risk of recession.
Although recent data has been encouraging, and a ‘soft landing’ for the US economy has become increasingly consensual amongst investors, the aeroplane is still at high altitude and there is still potential for turbulence ahead. It is too early to rule out a bumpier touchdown.
4 September 2023
20 “What we talk about when we talk about soft-landing” – JP Morgan – 28th August 2023