Because there will be a soft landing for the American economy
The US economy will make a soft landing. What will happen now? Analysis by Darrell Spence, Capital Group Economist
In recent months, much market commentary has focused on the possibility of the US economy making a “soft landing.” What is it exactly?
It is the situation in which an economy slows enough for inflation to fall, but not enough to result in a recession, something that many investors doubted would happen two years ago, when the Federal Reserve (Fed) began its fight against inflation.
We also believed that this eventuality was unlikely. Since then, however, inflation has fallen, job creation has declined but remains positive, and the U.S. economy has avoided a recession. The battle against inflation is not over yet, as it remains above the Fed's 2% target, but it is close enough to that target that Fed Chair Jerome Powell has promised a rate cut during his recent speech in Jackson Hole, Wyoming. If this reduction is approved at the September meeting, it will be the first rate cut since the COVID-induced recession in March 2020, marking the end of the historic two-year monetary tightening campaign initiated by the Fed in March 2022.
What will happen now?
While there is no official definition of a soft landing, for the purposes of this analysis it is considered to occur when real GDP growth expands, on average, for three quarters at a pace below the economy's potential growth rate (currently equal to 2.0% according to Congressional Budget Office estimates), without any real contraction being recorded in any of these quarters. If the US economy grows at an annualized rate of 1.5% in the third quarter of 2024, as projected by the current consensus estimate, it will have met the definition of a soft landing.
This would be a significant achievement, as in the past, when this scenario has occurred, the economy has tended to accelerate in subsequent periods. This pattern could repeat itself in 2025, especially if the Fed lowers rates.
Will we celebrate like in 1995?
If the economy makes a soft landing in the current quarter, the situation could be similar to the end of another aggressive Fed tightening cycle in early 1995, which ended with a Fed Funds rate of 6 ,0%. Despite that rapid increase, the economy expanded significantly through 2000, overcoming several financial difficulties, including the Mexican peso crisis, the devaluation of the Thai baht, the Russian default, and the collapse of the hedge fund Long-Term Capital Management .
During that period the Fed made modest adjustments to the Fed Funds rate: a 75 basis point cut, a 25 basis point increase, a 75 basis point cut again, and then a 175 basis point increase again to conclude the cycle at 6.5%, all while core inflation remained at or below the Fed's target of 2.0%. If the path were similar today, the Fed Funds rate could reach the cycle low of 4.125%, concluding the cycle at 5.875%.
In 1995, however, the US economy was weaker than today, with an unemployment rate of 5.5% (later falling to 3.8%). The unemployment rate is currently 4.3%, so a long expansion is less likely to occur. Furthermore, it is possible that the same level of interest rates will exert a greater drag on the economy today than then, due to higher debt levels and demographic changes.
Conversely, factors that could ease the drag on rate increases include fiscal stimulus, structural reshoring, and AI-related capital spending.
So far, however, the economy appears to tolerate rising interest rates. Despite recent concerns, the job market also appears to be holding up. The recent increase in the unemployment rate occurred in conjunction with the creation of 114,000 new jobs, indicating that the increase was primarily driven by the growth of the labor force. This is exactly what Fed officials hope for and would consider a soft landing, that is, an easing in the labor market that could moderate wage growth while employment continues to increase.
Of course, if the labor influx slows and the economy accelerates again in 2025, the unemployment rate could start to fall again.
Interest rate forecasts: better to moderate expectations
Based on interest rate futures market activity, investors expect the Fed to cut rates by 50-75 basis points by the end of this year and by more than 100 basis points in 2025. In my opinion, instead, the cuts will be lower. After some cuts, if the US economy continues to grow, or even accelerate based on past soft landings, and job growth remains solid, I doubt the Fed wants to risk overheating a healthy economy, in particularly if inflation remained above 2%, a possibility Powell indicated in his remarks last week.
Every time Powell intervenes, it feels like a Rorschach test: everyone hears what they want to hear and sees what they want to see, and I'm probably no exception. In my opinion the Fed will not cut rates as aggressively as the market expects. However, we admit that we thought any Fed cuts in 2024 were unlikely. Unless extremely surprising data arrives in the next couple of weeks, our forecast could be off by a few months. However, it is likely that 2024 will close with a substantially lower number of cuts than the market forecast at the beginning of the year.
If, early next year, the US economy expands above its potential growth rate, thanks to a rate cut or two, the Fed could declare mission accomplished and leave things as they are. It would make sense to pause monetary policy, given the importance of price stability after the worst inflation spike in 40 years.
Even with fewer cuts than expected, this environment could support stocks and bonds. A growing economy should provide support to stock prices over the long term, while rates could remain at a level that offers bond investors a real alternative to stocks.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/economia-usa-atterraggio-morbido-cosa-significa/ on Sun, 15 Sep 2024 02:37:48 +0000.