When it comes to predicting where the U.S. economy will go, the hardest part is choosing which battles to fight. For economists and forecasters, extremes are easy. The deluge of data and the pressure for attention leads many to declare that the sky is falling or that boom times are just around the corner. For central banks like the Federal Reserve, which has the even tougher task of keeping the economy in balance, getting the right amount of support and pressure right can be a difficult task.
This year, the difficulty was on full display. Most economists were worried earlier this year that the U.S. could slip into recession at any time. This prediction was based on questionable evidence, but it turned out to be wildly wrong as the American economy showed resilience throughout the year. I've always worried that the opposite could happen, that a strong economy could reignite inflation and force the Fed to start raising interest rates again.
While public forecasters stumbled throughout the year, the Fed appeared to find balance. Current economic indicators are consistent with a soft economic landing, where inflation cools without causing a recession or a spike in unemployment. And Federal Reserve Chairman Jerome Powell is in a more forgiving mood. Based on recent comments, it is highly unlikely that rate hikes will be back on the menu anytime soon, even if the economy suddenly shows signs of heating up again.
All of this is good news for American households, as the cost of borrowing money, from credit cards to mortgages, will gradually fall along with everyday expenses. This is also a favorable situation for financial markets. Stocks have fallen for nearly two years as bond yields soar. But with interest rates stabilizing, if not dropping a bit, price-to-earnings ratios are poised to rise sharply. If 2023 was a huge effort to stabilize the economy, 2024 will be the year we reap the rewards of that effort.
coming in for a soft landing
Signs of a balanced economy are everywhere. The most obvious example is slowing inflation. The core consumer price index, a widely cited measure of inflation that excludes volatile categories such as food and energy costs, has risen at an annualized rate of 2.8% since June, about half the pace it was at the start of the year. It becomes. And clear signs of continued disinflation are imminent. Wholesale auto auction prices suggest used car prices may start to fall, private measures of rental prices suggest housing inflation will continue to subside, and improvements in supply chains suggest. Prices of major non-automobile products, such as washing machines and clothing, will be reduced.
If 2023 was a huge effort to stabilize the economy, 2024 will be the year we reap the rewards of that effort.
Another positive signal comes from productivity data, which measures how much a worker outputs within an hour. Productivity growth particularly strengthened in the third quarter, reaching its highest non-recession level since 2003 and appears to be growing in line with pre-pandemic trends. Growth in people's working hours has slowed, but output has remained stable. This means people are accomplishing more in less time. This productivity increase means that as workers become more efficient, companies can increase employee wages without pivoting and pass those increased labor costs on to consumers in the form of price increases. .
Labor market conditions have slowed down, but not enough to cause panic about unemployment. Employment statistics for October were disappointing, with economic growth adding just 150,000 jobs and the unemployment rate rising to 3.9%. Particularly noteworthy is that the unemployment rate has increased by half a percentage point over the past six months. The rise in the unemployment rate is moving closer to triggering the SARM rule, which states an economy is in recession if the average unemployment rate over the past three months is 0.5 percentage points above the lowest level in the past 12 months. The current three-month average is 3.8%, a significant increase from April's low point of 3.5%, but not enough to reach the 4% average needed to trigger the rule.
But the job market isn't all bad news. Over the past three months, the average hourly wage for all employees has increased by 3.2%. That's a high number for U.S. workers and roughly in line with the Fed's long-term inflation goal. Furthermore, because tens of thousands of workers were on strike, it is likely that the previous employment statistics underestimated the growth in non-agricultural employment. (To be considered employed, you must be working.)
For now, I see what is happening in the labor market as a normalization and not a harbinger of increasingly worse news in the job market. A simple way to show that things are still in balance is to look at Okun's law, the relationship between movements in the unemployment rate and economic activity. Looking at changes in gross domestic product as an indicator of economic activity, the unemployment rate is below Okun's implicit rate, and the recent increase in the unemployment rate is within the expected range given economic growth and is not excessive. suggests that it is not. Too hot or too cold.
don't rock the boat
The challenge heading into 2024 will be maintaining this balanced economy. Just because things look good now, there is no guarantee that they will continue to be that way in the future.
The biggest risk to our country's stability is that a weakening job market could tip the economy into a deep recession. The problem with unemployment is that the unemployment rate is non-linear. The unemployment rate will not gradually increase. Historical records show that when the unemployment rate increases by 0.5 percentage points, the unemployment rate tends to rise further. The unemployment rate is already above the Fed's year-end forecast of 3.8%, the first time since March 2022. The door would be open if the unemployment rate could exceed the Fed's 4.1% forecast for year-end 2024. The government will cut interest rates relatively quickly. The Fed does not believe the situation has fundamentally changed about what constitutes a neutral economy, so further deterioration in the labor market would signal that tightening has gone too far and a change in direction is needed. Dew.
In an environment of benign labor markets and easing inflation, the Fed has ample rationale for surgical rate cuts, or modest policy readjustments to stabilize the outlook. The economic strength and easing financial conditions we've seen so far may limit the number of rate cuts, but the Fed could at least justify a modest change in policy stance. After all, a quick look at the Fed's historical rate cut record, shown in the nearby table, shows that the timing of the first rate cut is well within historical norms.
Of course, there are risks in the other direction as well. If the Fed starts cutting rates, economic activity could flare up enough for inflation to rear its ugly head again.
The clearest sign that things could be heading in this direction comes from your financials. This is a signal from investors that is implied through movements in stock prices, bond yields, and mortgage rates. For now, investors appear to be hoping for some Fed relief in 2024. Mortgage interest rates are falling, stock prices are rising, and corporate credit spreads are narrowing. This is fine given the slowdown in inflation that we have seen so far. However, there may be concerns about a more rapid acceleration in asset prices leading to higher inflation expectations. Fortunately, we are not there yet.
what has changed for me
Although there is a risk of upsetting the economic balance, the possibility of a calm 2024 becomes more realistic with each new data release. Yes, the economy is likely to slow, but after a strong third quarter, some slowdown was inevitable. It is important to stay calm and look at the big picture without getting carried away. Economic growth remains above 2%, which is thought to be enough to prevent unemployment from rising to the point where it puts pressure on people's incomes.
What has changed for me, considering the scenario for the next year, is that the probability of a surgical rate cut by the Fed has increased (by my estimate, this probability has gone from a 30% chance to a 50% chance). rose). On the other hand, the probability of further interest rate hikes next year has declined (from 50% to 30%). Also, the likelihood of a more aggressive easing cycle to address a broader economic slowdown remains unchanged (20%). Obviously, these are highly subjective probabilities. But I'm not into aggressive mitigation cycles. We believe the risk of a recession remains low. Real incomes are rising, household balance sheets are strong, other central banks around the world have already begun easing (likely to support growth), and governments are implementing expansionary fiscal policy. It is being implemented.
Although there is a risk of upsetting the economic balance, the possibility of a calm 2024 becomes more realistic with each new data release.
If I'm right and the Fed cuts interest rates even as the economy continues to grow at a modest pace, it will be a heavenly situation for stocks. Stock prices are already rising, but many stocks are underperforming the broader market. If the Fed actually cuts rates next year, it could give some of these laggards a boost.
In any case, this year's economy and markets have been quite the whirlwind, from recession to bust, and from bust to hard landing. The economy can be compared to a matrix between growth and inflation: deflationary collapse, moderate growth and moderate inflation, inflation boom, and stagflation. At this point, it is clear that growth is likely to continue as inflation slows.
Neil Dutta Director of Economics at Renaissance Macro Research.
