What a Soft Landing Would Look Like
And is it possible?
After hinging its inflation outlook too heavily on the word “transitory” during the middle days of the pandemic, thereby hoping things like temporary supply chain issues would settle themselves out over the course of time and ease consumer prices in the process, Federal Reserve officials suddenly found themselves behind the eight ball in the first half of 2022 with inflation running at its hottest levels since the early 1980s. All the the while, the labor market has been strong with the nationwide unemployment rate currently sitting at just 3.5%, matching the same rate as February 2020 immediately prior to COVID-19.
Longtime readers may be familiar with me writing about the Fed’s dual mandate, which in a nutshell means that the Fed is charged with both promoting price stability, which is understood to be an average inflation rate of 2.00%, and full employment, which is typically thought of as an unemployment rate between 3.50-4.50%. After more or less ignoring inflation for 2+ years, the Fed is now suddenly responding to excessively high inflation by raising interest rates at a historically brisk pace in order to cool off inflation.
I wrote in early February about how a strong jobs report in January was a direct link to rising interest rates in March, which is exactly what came to pass. That relationship has continued to play out all spring and summer long with continued strong jobs reports essentially giving the Fed permission to jack up interest rates in an effort to control inflation.
In Search of a Soft Landing
The Fed is walking a fine balance between trying to cool things off without pushing our economy into a tailspin. If it raises rates too much or too fast and business and consumer activity is choked off, the economy could enter a deep and painful recession. But if the Fed is too complacent, inflation may continue to run hot, which is also bad for the economy and the people in it.
If the term of 2021 was “transitory,” the term of 2022 is “soft landing.” Can the Fed engineer a soft landing to bring down inflation without tanking the economy? What would a soft landing look like?
I have four things in mind that I am watching in the weeks ahead:
Inflation - will inflation start to level off and, at the same time, can monthly jobs reports still show strength? On the one hand, it would be nice if inflation would ease to 3-4% by the end of the year, but if it doesn’t the Fed will have to continue to hike interest rates even after increasing them by 0.75% in both June and July. You can bookmark the dates of the upcoming Consumer Price Index data reports if you are a nerd like me: September 13th, October 13th, November 10th, and December 13th at 8:30 am. In the last report, which reflected the CPI numbers for July, inflation was still running hot, but the rate of inflation declined slightly over June, which perhaps is a sign of optimism that we have already passed peak inflation. I believe we have.
Jobs - what if inflation cools but the cost is millions of jobs lost due to a deteriorating economy? A soft landing would entail lower inflation without the sacrifice of jobs - a tough needle to thread, but not impossible given how strong the labor market has remained even as interest rates have quickly surged. It is easy to get lost in the data on all of this, but an increase in the unemployment rate of, say, one percentage point, represents millions of Americans who would be out of work with potentially devastating consequences to their families, livelihoods, and communities given the ripple effects of one person or one family’s loss of income.
Home prices - I have written a lot about home prices lately, in part because it is such an important indicator of the overall economy. If home prices spiral downward, it will be bad for the economy as homeowners suddenly find themselves with mortgage balances that are greater than the value of their homes. Sound familiar? While the current housing market is different than that of 2007-2010, there are still some worrisome signs out there including prices already dropping in certain markets. A soft landing for the economy vis a vis home prices would mean an easing of prices, perhaps a plateau for several years rather than a continued acceleration in prices or a significant drop. If homeowners start to lose value in their homes, they will also cut back on home renovation projects, which would negatively ripple through the economy as well.
Stocks - the stock market was down this past week, which was notable only in that it broke a streak of four straight weeks up. In fact stocks are up over 10% from their June lows as investors bet on the economy not entering a deep and lengthy recession. Investors can certainly be wrong (the so-called “smart money” often is), but the stock market is certainly pointing towards a soft landing for the overall economy right now.
Other indicators: every week a wealth of economy data is released, all of which helps to paint a picture of the overall economy and it relative health. Manufacturing numbers, consumer spending, shipping statistics: it all helps to tell the story. Even the earnings reports of certain bellwether companies like Walmart, McDonalds, and Disney are important to watch too. If these figures start to point south, the degree of difficulty that the Fed will face in “sticking the landing” will only increase.
Economists and media commentators seem to have come to terms with the perspective that the U.S. economy is probably going to enter a recession, and perhaps we are already there. There has been a good deal of social media kerfuffle lately about the true definition of a recession, which I’m not going to get into here.
But what people seem to also agree on is that this recession could be a weird one. I don’t know about you, but every time I eat out to dinner or travel or go shopping it feels like the economy is actually quite strong. Both the downtown area of the community where I live (Bangor, Maine) and the broader retail shopping area (the Bangor Mall area) have been really busy lately with lots of traffic. The Maine summer tourism season seems to be going very well with hotels and restaurants operating at full capacity, tempered only by how hard it is for many to hire enough workers.
All of his robust economy activitiy comes as consumer sentiment remains at extremely low levels. People might not be feeling good these days, but they are still spending money. How long that lasts will be the story for the last half of the year here in 2022 and into 2023.
My take: I see inflation cooling by the end of the year to that 4-5% level and then to 2-3% as 2023 progresses, but it will not be without some pain. I do not think we have seen the economic impact much yet of the recent increases in interest rates, but it will start to show by this fall as Americans suddenly find it much more costly to borrow and businesses find it more difficult to finance expansions and growth in the face of some economic headwinds. That said, I don’t think we are looking at a huge recession, but there is definitely turbulence ahead, and more so if you are in home construction or the real estate market after what has been a blazingly hot few years.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank.