Hard Landing? Soft Landing? Or No Landing?
The key points you should know.
The economy continued to grow at a solid pace through the first quarter.
The job market remains tight, but perhaps with some signs of slowing.
Inflation, while down substantially from a couple of years ago, remains too high.
The Federal Reserve still expects to start easing this year, but not yet.
A look back at the first quarter: Still no recession, but with sticky inflation.
The broadest measure of economic activity, growth in real GDP, slowed in the fourth quarter. (The first estimate for first quarter growth won’t be available until later this month.) Still, at an annualized pace of 3.4 percent it was strong and well above a sustainable rate (i.e., one that is consistent with stable prices). The details were strong, too:
“Core” growth (real private domestic final sales) was revised upward to annual growth of 3.3 percent (and up by 2.9 percent over four quarters).
The initial estimate of corporate profits for the quarter surged, helping to push real gross domestic income (GDI – the mirror image of GDP, as all spending is income to someone) up at an annualized pace of 4.8 percent. GDI growth had been barely positive in the four quarters before this and would have been more concerning if it were a better indication of actual economic strength than GDP is. While the four-quarter growth in real GDI is still below GDP, the difference is much smaller now – reducing recession concerns.
Moreover, the most recent (as of April 1) Atlanta Fed GDPNow estimate for the first quarter is 2.8 percent – slower, but still solid. Adding to second quarter growth is the ISM manufacturing survey index, which moved above the 50 break-even level for the first time since September 2022 – with the prices paid component up for three consecutive months and now at the highest level since July 2022. A rebound in the manufacturing sector is positive for the overall economy, but the impact on inflation is not positive (more below).
By most measures, the job market remains tight. Although the March employment report data will be released after this report is finished, data through February show that payrolls have increased between about 150,000-300,000 in every month over the past year – with February at the upper end of that range (up by 275,000). Even the bottom end of that range is above sustainable growth. The ratio of job openings to the number of unemployed workers has been falling for a number of months, but at 1.37 it remains elevated – there are more jobs to be had than there are people to staff them. On the other hand, the U-3 unemployment rate has edged higher from last April (3.4 percent) to February (3.9 percent). If the rate moves up to 4.0 percent in coming months, the Sahm Rule could be breached – suggesting that a recession has begun. And unlike the larger payroll survey, the household survey shows that employment has declined in four of the past five months (including the past three). So, while many measures show that the job market is solid, there are some measures suggesting that it may not be that rosy.
After surging in the post-Covid period because of supply constraints and record expansionary fiscal and monetary policy, inflation moved lower; and from August 2022 to October 2023, monthly gains in the overall CPI ranged between 0.1-0.5 percent. Consequentially, the 12-month trend rate dropped from 8.9 percent in July 2022 to 3.1 percent in June 2023. And with a monthly increase of just under 0.1 percent in October 2023, there were hopes that tighter monetary policy and healed supply chains had broken the back of inflation. Unfortunately, monthly CPI growth readings have increased in each of the following months, climbing to 0.4 percent in February. As a result, the trend rate in the CPI has flattened out at around 3.1 percent over the past five months. The inflation news has been similar for core inflation (removing the volatile food and energy components), with monthly core inflation rising from 0.2 percent to nearly 0.4 percent over the past seven months. The trend rate has continued to decline, however, in response to favorable year-ago comparisons – down to 3.8 percent in February. The broader inflation gauges using personal consumption expenditures (PCE), which the Fed prefers, have moved similarly, although at a lower level than the CPI (mostly from a lower weighting for housing measures) – with the overall trend rate at 2.5 percent and the core trend rate at 2.8 percent. Other inflation measures, such as the Cleveland Fed’s median CPI, have edged higher since the middle of last year – now up to 4.6 percent. Finally, as noted above, the price component in the ISM manufacturing survey has moved back into expansion territory.
At best, inflation declines have flattened out over the past several months, and many have moved higher. The important point is that almost all measures of inflation are still above the Fed’s long-term goal of 2.0 percent. This inconvenient fact has not gone unnoticed by financial markets and Fed policy makers.
Market expectations of Fed easing have changed significantly over the past six months, in terms of both when Fed easing might begin and how many easing moves are anticipated. Last fall, markets looked for six or seven Fed easing moves (of 25 basis points, each) beginning at the start of this year. Today, markets expect at most three easing moves starting in either June or July. The Fed’s own expectations of policy have changed as well, with the most recent “dot plots” from the March FOMC meeting showing a median expectation of three easing moves, but just barely over two.
Longer-term interest rates have responded to sticky inflation and changed Fed policy expectations by moving higher. The yield on the 10-year Treasury note, for example, increased from around 3.8 percent at the end of last year to around 4.3 percent today.
The updated outlook for 2024: Hard landing, soft landing, or no landing?
We presented three paths for the economy, plus estimates of the likelihood of each, in our 2023Q4 analysis of the economy (from early January). In that report, we posited a hard-landing scenario (recession in 2024), a soft-landing scenario (growth slowing to or below trend with inflation moving down to around the Fed’s goal), and a no-landing scenario (growth remaining solid and inflation staying above trend). While these scenarios are still in place, the probabilities of each of them occurring have changed based on more recent data. Note that the odds of the three scenarios don’t sum to 100 percent, as there are other less likely paths that the economy could take.
Hard landing
We gave a modest 2024 recession a subjective probability of 42 percent three months ago. Today, those chances have declined to around 20 percent. The precursors of recession are still in place: an inverted yield curve for a significant period of time and negative 6- and 12-month changes in the Conference Board’s Leading Economic Indicators (LEI) index. Why, then, have we reduced the odds of this scenario? Mostly because there are few signs of a near-term downturn in the economy, and it usually takes some time for the economy to weaken and drop into recession. The current picture suggests that if a recession does occur this year, it is more likely to be toward the end of the year, not in the next few months.
In a later-2024 recession, we should see a sharp rise in the unemployment rate, a drop in inflation, and easing by the Fed. All of these movements would probably be larger next year than this year, however, with even higher unemployment rates, bigger declines in inflation, and even more Fed easing – pushing interest rates down significantly.
Soft landing
While rare, soft landings do occur occasionally, and with growth slowing modestly and inflation moving lower, the chances of this path have increased. We gave the soft-landing scenario a subjective probability of 38 percent three months ago. Today, those chances have moved higher to around 40-45 percent. Economic growth and inflation are still above soft-landing levels, however, and would have to move lower – with real GDP growth at around 1.5-2.0 percent and inflation slipping to the Fed’s 2.0 percent goal. We would have given an even higher probability for this path, but persistent above-trend growth and the flattening out of inflation declines have tempered our views of even higher odds for a soft landing (and have raised the odds of the no landing scenario).
If a soft landing does occur this year, the unemployment rate may edge up a tad from current levels; inflation will cool again; the Fed may ease some (most likely twice, probably later in the year), and interest rates will decline again (reversing all of the recent rise in long-term rates). The most recent Fed dot plots would be a good guide for both this year and next.
No landing
Underlying economic growth remains solid, despite all of the caveats noted earlier in this report, while inflation declines have flattened out. Could the economy continue as it has over the past year? Certainly, it could, and the odds of this occurring have risen in recent months. We gave the no-landing scenario a subjective probability of only 12 percent three months ago. Today, those odds are up to around 30-35 percent. Interestingly, the greater the odds of a no-landing path this year, the higher the odds of a hard landing next year – as the Fed could tighten monetary policy further if inflation remains at current rates or moves higher in response to ongoing above-trend growth.
In a no-landing scenario, the unemployment rate would likely edge lower again as the demand for workers in an above-trend growth economy allows people to find employment more easily. But this would come at the cost of either flat or higher inflation – starting from a pace already above the Fed’s 2.0 percent goal. In response, there would be little chance of Fed easing, and it would be a good bet that the Fed would be forced to tighten monetary policy (at least modestly) in order to combat further above-trend inflation – likely pushing long-term rates up still more. But even more Fed tightening would eventually cause slower economic growth, raising the odds of a recession next year – with higher unemployment, lower inflation, and Fed easing in 2025.