Sep 4, 2023
Snapshot: Navigating the U.S. Economy’s Tightrope Between Growth and Recession
As the U.S. economy grapples with high-interest rates and inflation, there is rising concern about its ability to sustain current growth levels. While some quarters still remain optimistic, with a soft landing being the majority view, my analysis indicates warning signs that point toward a mild recession potentially emerging by the third or fourth quarter of 2024, or earlier, depending on specific economic triggers.
Tug of War: Assessing the Dual Forces Shaping Today's U.S. Economy
The State of the Economy
The current state of the U.S. economy presents a mixed picture, with both positive and negative influences that could impact its trajectory. On the one hand, the economy has been showing persistent above-trend growth, shown by the unexpectedly high GDP numbers as well as its tight labor market, as evidenced by robust spending and steady household savings as of July. However, there are also several factors that give rise to a more cautious outlook:
Inflation rates persist above the Federal Reserve's target, with the headline Consumer Price Index (CPI) registering at 3.2% and Core CPI at 4.7% for July.
Monetary policy reflects elevated interest rates ranging from 5.25% to 5.5%, constituting the highest levels in over 22 years, with additional hikes under consideration.
Bank lending conditions are tightening.
The labor market is starting to show some cracks, as seen from its most recent job opening report and consumer confidence report, with both starting to decline.
The impending resumption of student loan repayments in September/October presents a significant financial challenge to younger consumer demographics.
Consumer debt delinquencies are on the rise in areas such as credit cards and auto loans.
(Board of Governors of the Federal Reserve System (US), 2023)
(S&P Global, 2023)
The Tightening Grip: Federal Reserve’s Stance on Interest Rates
In an examination of the Federal Reserve's monetary policy direction, it is imperative to underscore the central bank's target inflation rate of 2%. In light of the unprecedented acceleration of inflation to a peak of 9.1% last June, the Federal Reserve has enacted a strong tightening policy. The benchmark interest rate has been hiked rapidly up to a range of 5.25-5.5%, constituting the highest levels in over 22 years.
(Trading Economics, 2023)
The Federal Reserve has been explicit in signaling that additional monetary tightening measures are on the horizon unless evidence of an economic slowdown materializes. This stance puts a laser focus on key economic indicators such as inflation rates and labor market data.
The recent Jackson Hole Symposium featured Federal Reserve Chair Jerome Powell's remarks, which I interpreted as having a hawkish tone. These remarks have reinforced the central bank's commitment to achieving its 2% inflation target. Powell was unequivocal in stressing that the institution still has work to do, and needs to be cautious. Investors and market participants should avoid complacency, as it seems highly unlikely that a rate cut will occur in the near future.
Furthermore, from previous statements made during sessions of the Federal Open Market Committee (FOMC), the Federal Reserve has emphasized its primary objective of combatting inflation. The consensus is that it is preferable to manage higher interest rates at present in order to control inflation rather than to cut rates prematurely and risk the re-emergence of persistent and stubborn inflation.
To summarize, the Federal Reserve's current trajectory suggests a preference for maintaining higher rates longer or raising interest rates potentially by an additional 25 basis points by the end of the year, depending on upcoming economic data. As the Federal Reserve continues to keep its policy rate restrictive, they will be paying good attention to real interest rates, and how they play out in the near term future, as they would want to avoid doing too much damage to the economy.
From all of this, I believe rate cuts are not on the immediate horizon and would only be precipitated by a dramatic decline in the inflation rate, such as the core Consumer Price Index (CPI) figures below the 2% target, coupled with a significant contraction in the labor market—essentially, a full-blown recession.
Pathways Ahead: Evaluating Soft Landing vs. Recessionary Scenarios
The Elusive Goal: Navigating the Complexities of a Soft Landing
With all of this data coming our way, the question on everyone's mind is whether the economy is headed for a soft landing, as the prevailing street consensus suggests, or whether there's an alternative scenario looming on the horizon. Achieving a soft landing is undeniably the most desirable outcome, but I believe it presents a formidable challenge for the Federal Reserve.
The Challenge of Achieving a Soft Landing
While a soft landing is unequivocally the most desirable outcome, its realization presents a complex challenge for the Federal Reserve. If the economy continues to strengthen while the labor market remains tight and inflation stays high, the Federal Reserve will likely hike rates, thereby increasing the odds of tipping into a recession. On the other hand, a weakening labor market and a cooling economy will likely make the Federal Reserve hold rates steady, which could lead to the possible path of a soft landing. However, the Federal Reserve will then face the significant challenge of deciding when to start lowering interest rates. The aim will be to avoid an economic recession while mitigating recurring inflation risk.
The Soft Landing Scenario
A soft landing involves an economy transitioning from growth to slower growth, eventually reaching a state of equilibrium, all while avoiding a recession. To attain this, there are several conditions which the Federal Reserve would likely need to meet:
Economic Slowdown: A gradual reduction in economic activity is crucial. As indicated in the July FOMC meeting, the Federal Reserve's confidence in achieving its inflation target will remain elusive unless there is a discernible slowdown.
Cooling Labor Market: Recent data has shown some signs of a slowing labor market, such as cooling wages, supporting the view that a soft landing could be possible.
The good news is that we are not experiencing the same kind of upward pressure on inflation as before. Nonetheless, we are still above the ideal 2% inflation target.
Walking the Tightrope: The Federal Reserve's Margin for Error
Achieving a soft landing is a highly delicate operation. Even if all variables line up—such as a gradually cooling labor market and inflation—it still leaves the Federal Reserve with a tightrope to walk. Decisions to cut rates are fraught with risk due to lagging economic data and the need to prevent an economic slide into recession. In addition, the risk of cutting rates too soon could cause other significant problems, such as recurring and sticky inflation, which is the worst-case scenario. Therefore, the Federal Reserve faces the daunting task of threading a needle, one that history suggests is laden with pitfalls.
Ultimately, while a soft landing is the most appealing course, the intricacies of achieving it are formidable. Contrary to the optimistic Wall Street consensus, the Federal Reserve's task is far from straightforward. Given the lag in economic data and the fine margin for error, the Federal Reserve's ability to steer the economy towards a soft landing will require an almost surgical level of precision—a task that remains highly challenging.
The Looming Mirage: Why a Mild Recession is More Likely Than a Soft Landing
Given the significant challenge the Federal Reserve faces to achieve a soft landing, a mild recession is a more probable outcome for the economy. Even though some of the current data suggests otherwise, there are some factors that people might be overlooking.
The Challenge of Monetary Policy Lags
The Federal Reserve has recently implemented a series of interest rate hikes, the highest in over 22 years, to curb inflationary pressures. However, considering the principle of long and variable lags in monetary policy, I believe that the full impact of these changes has yet to be experienced. While financial markets may react almost immediately to changes in monetary policy, real economic variables such as employment, consumption, and business investment tend to respond much more slowly and unpredictably.
The Buffer: Strong Labor Market and Consumer Spending
For the time being, the U.S. economy appears to be holding steady, buoyed by a robust labor market and strong consumer spending fueled by savings accumulated during the COVID-19 pandemic stimulus. This situation might lead some to believe that the economy is heading towards a "soft landing"—a scenario where economic activity slows but does not contract.
Warning Signs: The First Wave
However, initial signs point to a different conclusion. We are already witnessing a softening labor market and a rise in credit card and auto loan consumer delinquencies. In addition, credit card debt has also hit an all-time high, indicating the beginnings of financial stress for households. Commercial Real Estate is also showing signs of strain due to the current high rates. Recent bank failures, particularly among those with weak balance sheets, serve as early warnings. Increasing consumer debt and weakening consumer confidence suggest that household balance sheets may start contracting soon. It is crucial to remember that monetary policy works with long and variable lags, as Federal Reserve Chair Jerome Powell recently emphasized. The tightening initiated by the Federal Reserve has likely just started to impact the real economy, and the full brunt of the policy is yet to be felt.
The Second Wave: A Mild Recession
The current stability should not be mistaken for resilience. As companies begin to cut back due to less spending by consumers, they will start more layoffs and less hiring, causing a slowdown and a rise in unemployment rates. If higher interest rates persist, companies will need to begin refinancing at those higher rates, placing additional stress on their financial health. High-interest rates will eventually impact both consumer spending and business investments negatively. I argue that as the "main wave" of monetary policy effects catches up, the U.S. will likely face more than just a gradual slowdown. As household balance sheets dry out and the labor market begins to contract, we could enter into a mild recession. This outcome would be more aligned with the unpredictable and prolonged nature of monetary policy lags rather than the quick adjustments that a soft landing would imply.
Final Thoughts: Navigating the Uncertainty of Long and Variable Lags
In summary, while the current data may suggest that the economy is strong enough to withstand high-interest rates, the concept of long and variable lags warns us to prepare for delayed, unpredictable responses. Added to this, credit card debt is reaching an all-time high, and issues in commercial real estate signal early warning signs. With companies looking at the possibility of refinancing at higher rates and households facing contracting balance sheets, the future appears to be far more unstable. This suggests that we are in a precarious period of waiting for latent effects to materialize—though immediate indicators may be absent, the full impact of these conditions is yet to unfold.
Anticipating What Lies Ahead: A Cautious Outlook
Given the Federal Reserve's difficult balancing act, the economy is perched on the edge of two possible outcomes: a soft landing or a mild recession. While current economic indicators offer some comfort, they also hold cautionary tales. The rise in consumer debt, the softening labor market, and the delayed impact of monetary policy could precipitate a rapid disintegration. In this intricate scenario, caution and vigilance are essential. The pathway we find ourselves in is filled with uncertainties that have yet to fully materialize, making the need for forethought and adaptability more crucial than ever.
However, given the fluidity of economic indicators and market conditions, it is crucial to remain vigilant and adapt investment strategies in response to incoming data. I remain committed to rigorously evaluating forthcoming data sets, and my analytical perspectives may undergo revisions in response to evolving economic conditions.
Disclaimer: The views expressed in this report are based on current data and may be updated in response to new information. Investors are advised to exercise vigilance, adapt strategies as needed, and conduct their own due diligence before making investment decisions.
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