In March of the year 2022, amidst a 7.9% year-over-year surge in prices as per the consumer price index, the Federal Reserve enacted an increase of 25 basis points in the federal funds rate. This marked the first increase in the federal funds rate since December 2018. Subsequently, interest rates have risen by a significant 525 basis points to a range of between 5.25% to 5.5%.
A lot has changed since March 2022. Notably, the headline CPI has receded to 3.2% year over year, while the U.S. economy has demonstrated a surprising degree of resilience. This favorable trajectory has instilled confidence in many regarding the Federal Reserve's potential to engineer a soft landing, defined as bringing inflation back to the two percent target without causing a recession. The recent trajectory of economic data supports this soft landing narrative, fostering substantial optimism within the equity and bond markets.
Yet, amidst this buoyant sentiment, the key question is: What is the likelihood that the Federal Reserve can effectively bring inflation to the designated two percent target without causing a recession?
Positive Sentiment on the Equity Market
During the month of November, the S&P 500 experienced a notable increase of 8.2% as of the close on November 21st. This has happened merely six times since 1928. Moreover, the Relative Strength Index, functioning as a pivotal momentum indicator for the S&P 500, underwent a substantial increase. It rose from a reading of 30 at the end of October, signifying oversold conditions, to its present reading nearing 70, a clear indication of overbought levels.
During the course of the year 2023, a strong correlation has been observed between the fluctuations in the 10-year treasury yield and the performance of several key U.S. stock market indices. Recent weeks have witnessed a notable decline in the 10-year treasury yield, an occurrence that has boosted the overall performance of these U.S. stock market indices.
In recent weeks, a notable surge in equity prices has been attributed to a singular factor: the sustained optimism caused by economic data. This data consistently reinforces the belief that the Federal Reserve possesses the potential to restore price stability without causing a recession. Put differently, the prevailing economic data consistently reinforces and aligns with the narrative of a potential soft landing, causing increased market confidence and subsequent rises in equity prices.
October Jobs Report and Other Labor Market Data
The pace of job gains nearly halved in October to 150,000 and the unemployment rate increased to 3.9%. percent.
Average weekly hours fell to 34.3, which is a sign of cooling employer demand. Additionally, wage growth has come down from close to 6% at the beginning of 2022 to 4.1% in October. Larry Summers, the former U.S. treasury secretary, said to Bloomberg recently “You cannot get inflation down without getting wage inflation down”. A slowdown in wage growth is considered to be required to bring inflation back to the Fed’s two percent target.
Additionally, the number of continuing U.S. jobless claims recently rose to 1,865,000, which is almost a two-year high, and initial jobless claims are also posting an upward trend.
What can we conclude from the recent U.S. labor market data? Jerome Powell has often noted that bringing inflation back to two percent requires moderation in labor market conditions. The renowned economist Mohamed El Erian stated on Bloomberg that the October jobs report is “Goldilocks for markets, consistent with a soft landing for the economy.”
October Inflation Report
Another contributor to the stock market rally is inflation data. In October, headline inflation fell from 3.7% to 3.2%. Excluding shelter prices, inflation was only 1.5% higher annually. Core CPI reached a two-year low of 4% on an annual basis. Meanwhile, import prices fell 0.8% in October. This inflation data supports the disinflationary trend that we have seen in the past few months.
Additionally, the producer price index (PPI) posted an unexpected 0.5% decline in October, compared to the 0.1% expected increase. This was the biggest drop since April 2020.
The recent inflation data supports the disinflationary trend that we have seen in the past few weeks which raises the hope that the Federal Reserve could achieve a soft landing.
All of the data previously mentioned would not support the soft landing narrative if it wasn’t backed by strong economic growth. While inflation continues to fall and labor market conditions continue to moderate, the U.S. economy continues to grow. In the third quarter, U.S. GDP increased at an annual rate of 4.9%, driven by an acceleration in consumer spending, inventory accumulation, and a boost from government spending.
The Federal Reserve
Falling inflation and moderating labor market conditions convinced traders that the Fed was done raising interest rates. Does this match with the intentions of the Federal Reserve? According to Lindsey Piegza, there are three key takeaways from recent notes from the November fed meeting minutes. The first is that the fed will proceed cautiously. The minutes state that “All participants agreed that the Committee was in a position to proceed carefully and that policy decisions at every meeting would continue to be based on the totality of incoming information, "The second is that the fed continues to be data-driven. The minutes state that “Participants expected that the data arriving in coming months would help clarify the extent to which the disinflation process was continuing…” Lastly, inflation still is unacceptably high. According to the minutes, “Participants noted that inflation had moderated over the past year but stressed that current inflation remained unacceptably high and well above the committee’s longer-run goal of 2%,” according to the minutes. They also stressed that further evidence would be required for them to be confident that inflation was clearly on a path to the committee’s 2% objective.
What key insights emerge from the meeting minutes and recent communications from the Federal Reserve? In the past few weeks, the fed highlighted two primary risks: firstly, the potential of being misled by a few months of positive economic data, and secondly, the risk of overtightening. Consequently, while the Fed's confidence in the sustainability of inflation's trajectory toward the two percent target remains uncertain, it aims to maintain a flexible policy stance to leave the door open for a soft landing.
Economic Data Supports the Soft Landing Narrative
Recent data suggest that economic growth in the U.S. is still strong, inflation is falling, and labor market conditions are moderating. Additionally, the Fed will likely remain on the sidelines to minimize the risk of overtightening and the risk of being misled by a few months of positive economic data. All of this is consistent with the soft landing narrative.
Unfortunately, the apparent clarity presented by the aforementioned data points is misleading. It's important to acknowledge that the impact of monetary policy on the economy operates with long and variable lags, and it's plausible that the full effect of the previous interest rate hikes has not been felt in the real economy yet.
The Resilience of the Consumer
Jason Draho at UBS Global Management said to Bloomberg recently “The markets are priced for a soft landing, and thus for consumer spending to hold up.” This underscores the pivotal role of robust consumer spending as an essential prerequisite for the Federal Reserve to achieve a soft landing. Notably, the resilience of the U.S. economy has predominantly been caused by the strength of the consumer. U.S. consumers continue to spend, which is a trend supported by the recent Black Friday sales.
As noted by Spencer T. Hakimian, the founder of Tolou Capital Management, the Q4 shopping season is critical to the growth of the overall economy. For example, the period from Thanksgiving to Christmas has accounted for almost 10% of annual retail sales historically. Black Friday digital sales were better than expected and they are poised to set a new record. In 2023, Black Friday digital sales grew by 7.5% Year over Year to $9.8 billion. However, the increase in digital sales can be considered to be an indication that price-conscious consumers want to spend on the best deals and are hunting for those deals online. Vivek Pandya, a lead analyst at Adobe Digital Insights believes “We’ve seen a very strategic consumer emerge over the past year where they’re really trying to take advantage of these marquee days so that they can maximize on discounts,” Additionally, according to an Adobe survey, $79 million of the sales came from consumers who opted for the ‘Buy Now, Pay Later’ flexible payment method to stretch their wallets, which is an increase of 43% from last year.
While this can be considered as an indication that consumer spending is starting to wear off, many factors could put the U.S. consumer under pressure further down the road. Firstly, consumers are running down their savings to finance spending. The personal savings rate has declined from 5.3% in May 2023, to 3.4% in September 2023. Additionally, consumers are facing higher borrowing costs, labor market conditions are moderating, student loan repayments are resuming, and inflation still is persistently high. Major U.S. retailers have also reported a deceleration in consumer spending. Best Buy Co. and Lowe’s Cos. revised their forecasts downward, citing a decline in discretionary spending, while Kohl's reported a seventh consecutive decline in comparable sales. Nordstrom's CFO, Cathy Smith, recently remarked, "We continue to observe a cautious consumer, and the implications of inflationary adjustments, heightened interest rates, and the resumption of student loan repayments on discretionary consumer spending during the holiday season remain uncertain." Furthermore, retailers primarily serving wealthy Americans are witnessing a pre-holiday decline in sales. The chart below indicates a median sales decline of 14%, marking the weakest performance in two years. Consumer spending is decelerating.
Kayla Bruun, senior economist at Morning Consult, informed Bloomberg, "The upper-middle class had been the driving force behind much of the unexpectedly robust spending. Now, households with at least $100,000 in annual income are beginning to exhibit greater frugality." Should consumers face excessive pressures, the Federal Reserve's ability to engineer a soft landing becomes doubtful. It is crucial to keep an eye on consumer spending and the resilience of consumers.
Conference Board Leading Economic Index
The Conference Board Leading Economic Index (LEI) aims to provide an early indication of significant turning points in the business cycle and to forecast future economic activity. In October, the Leading Economic Index for the U.S. fell by 0.8%, following a decline of 0.7% in September. According to Justyna Zabinska-La Monica, Senior Manager at the Conference Board, among the leading indicators “deteriorating consumers’ expectations for business conditions, lower ISM index for new orders, and tighter credit conditions drive the index’s most recent decline.”
The LEI has exhibited a persistent decline over twelve consecutive months. Philippe Gijsels, the Chief Strategy Officer at BNP Paribas Fortis, has noted that a sustained downturn in the Conference Board Leading Economic Index typically signals the onset of a recession. This correlation is graphically represented below. The LEI is pointing toward further economic weakness in the near future, which speaks against the Federal Reserve achieving a soft landing.
Since the Federal Reserve started raising interest rates, delinquency rates, and default rates have increased. This is a clear representation of how the cumulative effect of the previous interest rate hikes is starting to bite in the real economy. According to Torsten Slok, chief economist at Apollo, the ongoing rise in default rates is “not just a normalization. It is a direct consequence of fed hikes. The fed is trying to slow the economy down.” Card loans rose 1.6% month over month in October across five big U.S. card lenders. A seasonal typical increase would be 0.7%. While this suggests that consumers are willing and able to use their credit cards to spend money, more people are struggling to pay back loans. The average 30-day-plus delinquency rate across the five big lenders rose 0.16% in October, compared to a seasonal typical increase of 0.06%. Additionally, a recent study from the Boston Federal Reserve found that consumers with an annual household income below $50,000 whose accounts were delinquent are now utilizing between 80% and 90% of their available credit which means that, according to the Boston Fed, “those consumers with a very small amount of credit on their accounts” do not have a “cushion against a deterioration of their financial situation.” The recent senior loan officer opinion survey shows that “significant net shares of banks reported tightening lending standards for credit card and other consumer loans.” Additionally, a record-high amount of consumers are saying it is harder to obtain credit, as indicated by the chart below.
Thus far, the strength of consumer spending has been supported by elevated savings. However, as noted previously, savings are being depleted. Moreover, the enduring resilience of the labor market, albeit showing signs of moderation, continues to support American consumers.
When considering the rise in delinquency rates alongside the five factors potentially intensifying pressure on consumers, it becomes increasingly apparent that the fundamental condition necessary for a soft landing—a resilient consumer base—might face challenges in sustaining its resilience over an extended duration.
Despite the progress that the Fed made in bringing inflation closer to the 2% target, inflation expectations have recently increased. Torsten Slok from Apollo believes when inflation expectations are on the rise “the Fed cannot begin to send dovish signals”.
The increase in inflationary expectations is graphically depicted in the chart provided below. A sustained rise in these expectations increases the likelihood that the Federal Reserve will be compelled to maintain interest rates at an elevated stance for an extended duration, consequently increasing the risk of prospective economic weakness. Should interest rates persist at elevated levels for an extended period, the prospect of attaining a soft landing could diminish correspondingly.
Why has the U.S. economy remained so resilient despite many interest rate hikes?
Some may wonder why the U.S. economy has remained so resilient in light of a notable increase of over 500 basis points in interest rates imposed by the Federal Reserve. This phenomenon has been surprising to eminent figures in finance and economics. Forecasts, including those made by PIMCO, anticipated a bullish trajectory for bonds in 2023, a projection that did not materialize. Geraldine Sundstrom of PIMCO conveyed to Bloomberg that the anticipated transmission of monetary policy did not unfold expectedly, primarily attributed to factors such as increased savings, consumer resilience, and the prevalence of fixed-rate mortgages across various economies. However, she believes that the current scenario might only represent a delay in anticipated outcomes rather than a complete deviation from projections.
The onset of economic challenges in Europe and the UK, economies known for being sensitive to interest rate hikes, contrasts with the U.S., which displays a relatively lower sensitivity to monetary policy tightening. However, the convergence is toward more slowing in the U.S. instead of a global rebound, according to Geraldine Sundstrom. This is yet another factor that is speaking against the Fed achieving a soft landing.
The chart provided below underscores the argument that the transmission mechanism of monetary policy in the U.S. has weakened. Presently, approximately 22% of mortgages have interest rates below 3%, a stark contrast to the 1% observed in all mortgages back in 2019.
According to Torsten Slok, chief economist at Apollo, “locking in of lower mortgage rates has weakened the transmission mechanism of monetary policy”. Hence, the Federal Reserve might have to keep interest rates at a higher level for longer to achieve the desired effect of the tightening cycle. As noted earlier, this decreases the chance of a soft landing.
How likely is a soft landing?
When considering the aforementioned factors, a deceleration in economic activity within the United States becomes increasingly challenging to argue against. Presently, economic momentum is showing signs of deceleration, causing uncertainty regarding the extent of potential future deterioration. Examination of leading economic indicators, notably the Conference Board's Leading Economic Index (LEI), speaks for a higher probability of continued economic fragility throughout 2024. Peter Cecchini of Axonic Capital, in recent discussions with Bloomberg, underscored a historical absence of the Federal Reserve's successful orchestration of a soft landing amidst the rapid increase in real yields. Moreover, the renowned economist Mohamed El Erian has often expressed his worries about the cumulative effect of the previous interest rate hikes. Monetary policy affects the economy with long and variable lags, and we unfortunately do not know how long and variable those lags are. The extraordinary resilience demonstrated by the U.S. economy has depended greatly upon the strength of consumers, a crucial prerequisite for achieving a soft landing. However, an assessment of multiple indicators indicates a potential diminishment in consumer resilience. Should this trend persist, it could decrease the prospects of achieving a soft landing. Drawing from the aforementioned data points, it appears increasingly unlikely for the Federal Reserve to navigate the U.S. economy toward a soft landing.