Soft Landing Is Possible – With Inflation and Luck

Summary

• The expansion has a lot longer to go, provided the Federal Reserve (Fed) tolerates high but stable inflation.
• But eventually the Fed would have to react to sticky inflation by resuming hikes, gradually, and sometime around mid-2024.
• The main risk to this rosy scenario is that the ongoing oil rally proves sustainable beyond $90/barrel, which could accelerate core inflation.
• In such an instance, the Fed would hike sooner and more aggressively, possibly bringing the end-2024 Federal Funds Rate (FFR) close to the Taylor rule, which I estimate at about 7 to 8%.

Market Implications

• Even in the absence of an oil price shock, inflation stickiness implies that the Fed will hike more in 2023 and 2024, which compares with about five cuts currently priced by the markets.

No Reason Why Growth Cannot Keep Going

Growth has been accelerating (as I expected) and there is no reason why this cannot continue (Q3 2023 GDP: Growth Accelerates). On the demand side, fiscal and monetary policy are expansionary and the households savings rate remains at a post-GFC low (Core PCE to End 2023 Above 4%). And as I expected, bank failures did not turn out to be macro events (The Recovery Is Not Credit Dependent).

On the supply side, employment growth is slowing but still going at close to 2.5% YoY (NFP Review-Still Hot). In addition, labour productivity, following an unsustainable increase during the pandemic (caused by the shortage of workers), seems back to its pre-pandemic trend of about 1.5% YoY (Chart 1). GDP growth could easily continue growing above trend of about 2%.

Favourable demand and supply underpinnings of growth explain why indicators such as forward looking spending, i.e., durables consumption and non-residential investment, as well  as real household income growth, historically a good predictor of expansion, have been so strong (Macro Indicators for Reluctant Rally Participants).

Strong Growth Implies Stable Inflation

In the soft landing scenario, inflation is more likely to remain above 4% than go back to the Fed’s target. 

Core goods price inflation has been volatile but is unlikely to go back to the pre-pandemic deflation, for two reasons (Chart 2). First, deglobalization (i.e., the shortening of global supply chains, reshoring, and protectionism) suggests rising costs. Second, climate change is shaping up to be a broad-based negative productivity shock, through the impact of extreme weather on, for instance, transportation costs, the need for extreme weather mitigation measures, or damage to productive capacities, a topic I will explore in future research. 

This leaves the weight of bringing down inflation squarely with services. Historically core services and wages have tended to track closely (Chart 2). 

Wage growth is slowing. In June, 12m/12m YoY growth was about 4.5%, down from a peak of 5.5% in September 2022. But wage growth would have to get much closer to 2% for core inflation to get back to 2%.

And historically, large (i.e., 1.5% or more) slowdowns in wage growth are preceded by recessions (Chart 3). The current slowdown is an exception and, in my view, reflects in part the ongoing YoY decline in energy prices that has allowed real wage growth to accelerate despite a slowdown in nominal wages. 

In addition, the current wage growth slowdown also reflects that the 2021-22 acceleration was exceptional—the largest since the oil shocks of the 1970s! In my view, it reflected labour shortages that have now by and large disappeared. 

Due to this labour market normalization, the traditional relation between wage growth and unemployment is bound to reassert itself. That is, a continuation of the wage growth slowdown will require a sustained rise in unemployment, unlikely if growth remains at or above trend.

Carving out housing from core services does not change this analysis. Core services ex housing and housing tend to track closely. This reflects that housing costs track wages rather than home prices (Chart 4). Homes are an asset, while housing costs are the cost of services derived from this asset. Housing costs are therefore driven by factors such as interest rate, depreciation, and maintenance cost, as well as renters’ ability to pay (i.e., wages).

Even A Dovish Fed Would React to Sticky Inflation

The Fed has so far accommodated a much greater deviation of inflation from target than increase in unemployment, which signals a bias towards dovishness (Chart 6). Its core PCE forecast for Q4 2023 has increased gradually to almost twice the official inflation target and at 3.9%, is not far from the June core PCE print of 4.1% YoY. So it is plausible that PCE could end 2023 within striking distance of the Fed forecast. In such an instance, the Fed would stop at its planned additional 2023 hike.

The real test of the Fed’s willingness to tackle inflation is likely to come in 2024, when the Fed expects core PCE to slow further to 2.6% by Q4. The above discussion suggests this is   unlikely to happen based on current policy settings. 

With its dovish bias, the Fed would likely respond to sticky inflation first by reducing its planned 100bps of 2024 cuts. Eventually the Fed would resume hiking, gradually, and sometime around mid-2024. For instance, 25bp in June, September, and December. 

As long as the market believes the Fed will eventually return inflation to 2%, and breakevens and nominal yields remain stable, the combination of strong growth, high but stable inflation, and a dovish Fed would be very supportive of risk assets.

Inflation Risks Biased Upwards

The risk associated with the soft landing is that it keeps the US in what the BIS defines as a high inflation regime, where shocks such as increases in energy prices pass through quickly to core inflation. This is because in a high inflation regime economic agents are very attuned to signs of inflation and quickly incorporate their perceptions of inflation into their wage and price behaviours. As a result, goods and services prices across the economy have a strong common component.  

In this regime, inflation becomes entrenched and wages and prices across the economy adjust quickly to shocks, such higher energy prices.

By contrast, in a low inflation regime, economic agents practice ‘rational inattention’ (i.e., they ignore small price changes because they will not impact much real income or wages). As a result, inflation is self-stabilizing and there is limited pass through from higher energy prices to core inflation.

The change in passthrough from energy to core inflation can be seen on Chart 8, where in the 1970s and 1980s there was strong correlation between energy and core PCE. With inflation getting close to 2%, the correlation disappeared in the 1990s and up to the COVID-19 pandemic.

With the high inflation of the pandemic, the passthrough from energy to core inflation made a comeback. This suggests the US is already in the high inflation equilibrium. The risk therefore is that an energy price shock could see core inflation start accelerating again.

It is too soon to tell if the ongoing rally in oil prices has legs (Commodities Weekly: US Oil Production Has Peaked). But if oil prices get past $90/barrel in a sustainable manner, they will turn positive YoY and likely start passing through to core inflation. The Fed would then feel compelled to react with more aggressive tightening.

Market Consequences

Without an oil price shock, the combination of strong growth, high but stable inflation, and a dovish Fed has further to go. Even if inflation turns out stickier than the Fed expects, it likely will not resume hikes until mid-2024. In such an instance, the Fed would likely resume hikes gradually, with for instance, a hike at every other meeting starting in June.

By contrast, with an oil price shock core inflation is likely to accelerate again. The build-up of supply and demand conditions that would lead to an undersupplied market is likely to be a Q4 event. In such an instance, the Fed would start hiking sooner and more aggressively and would bring the end-2024 FFR closer to the Taylor rule, which I estimate to be about 7 to 8%.

These views compare with market pricing the June 2024 FFR at 4.8% and the December 2024 FFR at 4.1%.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)