With the Federal Reserve engaged in a bold monetary tightening campaign, many pundits and economists are debating whether the economy is headed for a “hard” or “soft” landing. In the post-World War II era, there have been three soft landings following a Fed rate hike campaign – 1965, 1984, and 1994. The difference between then and now, however, is that the Fed was trying to prevent inflation previously, versus its efforts today to reduce already high inflation.1
The inflation setup is a key differentiator. But I still think there’s a strong case for a soft landing in the current environment. The Fed needs inflation to come down, and to get there its main objectives are to slow GDP growth to around 2% or less, to bring some balance back into the too-tight labor markets, and to slow wage growth.
I think it’s possible to accomplish all three with a mild recession, not a severe one.
On the economic growth front, we’ve already seen softening GDP figures with earnings and earnings estimates coming down, signaling that the Federal Reserve and other global central bank measures are having at least some effect in reducing demand in the global economy. S&P 500 profit margins have also peaked, which generally implies an economic slowdown is underway or nearby. In the US housing market, 30-year fixed mortgage rates have shot past 6%, which has resulted in seven straight months of declines in existing home sales. Permits for future homebuilding have also plummeted to levels last seen in the spring of 2020.
Regarding the rebalancing of supply and demand in the labor market, the optimistic view is that the Fed could theoretically achieve this goal by reducing the number of job openings instead of slowing the economy to the point of triggering layoffs. August employment data showed an early sign of this possibility, with total job openings falling by 10% to 10.1 million (see the dip in the blue line below). This figure still far exceeds the 6 million unemployed people looking for work (red line), so the real task here is closing the gap between the two. One month’s worth of data does not make a trend, but the 10% dip in job openings seems to be a meaningful step in the right direction.
September payrolls showed some further signs of cooling in the labor markets. Employers added 263,000 jobs in the month, which is a strong figure but notably smaller than the August increase of 315,000 and the 400,000 average gain over the first six months of 2022. Hourly wage growth was 5.0%, which is lower than August’s 5.2% gain and marked the slowest pace of increase since December 2021. Somewhat problematically, however, was that the number of people in the labor force fell, which brought the unemployment rate down to 3.5%. More labor is needed to ease wage pressures.3
Other factors supporting an economic soft landing are strong fundamentals in the private sector and for households. The private sector has shown few signs that leverage is becoming an issue, and banks continue to report strong financial conditions. Households have spent down a decent portion of accumulated savings following the pandemic, but there is still approximately $1 trillion of net excess savings on balance sheets. The legacy of low-interest rates is also keeping debt service costs historically low for a majority of Americans, as seen in the chart below.
Bottom Line for Investors
I think the next few months will start to show evidence that inflation pressures are easing, which should start to initiate conversations at the Fed about where the peak in interest rates may fall. On the inflation front, rents are falling month-over-month in many major markets, commodities are at a seven-month low and trading far from peaks, retail inventories are elevated which is forcing many retailers to cut prices, container freight rates are falling sharply, and the US ISM Manufacturing Prices Paid Index is currently at 51.70—down -36.33% from a year ago. All of these factors point to reduced inflationary pressure in the months ahead, which also coincides with inflation expectations as seen on the chart below:
The key for markets is if the peak in inflation comes before the Fed has gone too far with rates, which would significantly increase the chances we get a soft economic landing. Falling inflation could also be good for stocks – throughout history, stocks fall as inflation approaches a peak, but they rebound strongly once inflation starts to come down. I think we’re getting close to this point.
1 Wall Street Journal. September 7, 2022. https://www.wsj.com/articles/the-case-for-a-soft-landing-high-inflation-could-end-without-recession-11662555602
2 Fred Economic Data. October 4, 2022. https://fred.stlouisfed.org/series/JTSJOL
3 Wall Street Journal. October 7, 2022. https://www.wsj.com/articles/september-jobs-report-unemployment-rate-economy-growth-2022-11665091101
4 Fred Economic Data. September 30, 2022. https://fred.stlouisfed.org/series/MICH
5 Fred Economic Data. September 30, 2022. https://fred.stlouisfed.org/series/MICH#
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