After three years of pain, America has finally achieved economic nirvana

When it comes to predicting the course of the US economy, the hardest part is choosing which battles to fight. For economists and forecasters, it is easy to go extreme – the deluge of data and the pressure to be noticed leads many to declare that the sky is falling or that the boom is just around the corner. For a central bank like the Federal Reserve, tasked with the even more difficult job of maintaining balance in the economy, landing on just the right amount of support or pressure can be a tough task.

The difficulty was fully apparent this year. Most economists began the year worried that the US would fall into a recession anytime. This prediction was based on dubious evidence, and as the US economy proved resilient over the course of the year, that turned out to be completely wrong. For my part, I was always worried about the opposite: the possibility that the strong economy would bring back inflationwhich forces the Fed to increase its rate hikes.

While public forecasters stumbled throughout the year, the Fed appeared to pull off the balance sheet. Current economic data is consistent with a soft landing for the economy – a situation where inflation cools without causing a recession or sudden increase in unemployment. And Fed Chairman Jerome Powell is in a more forgiving mood: Based on recent comments, it’s 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 decrease along with everyday expenses. It is also a favorable setup for the financial markets. Stock prices have shrunk for almost two years as bond yields have risen. But with rates stabilizing, if not falling slightly, equity returns are poised to boom. If 2023 was about the hard work of stabilizing the economy, 2024 is about enjoying the fruits of that work.

Coming in for a soft landing

The signs of a well-balanced economy are everywhere. The most obvious example is the decline in inflation. The core consumer price index, the widely cited measure of inflation that strips out volatile categories such as food and energy costs, has risen since June at an annual rate of 2.8%, about half the pace heading into the year. And there are clear signs of continued disinflation on the horizon: Wholesale vehicle auction prices suggest that used car prices may begin to fall, private measures of rental prices suggest that housing inflation will continue to cool, and an improvement in supply chains suggests that core commodity prices outside cars, including washing machines and clothes, will lighten.

If 2023 was about the hard work of stabilizing the economy, 2024 is about enjoying the fruits of that work.

Another positive signal comes from productivity data, which measures a worker’s output within an hour. Productivity growth strengthened significantly in the third quarter, reaching its highest non-recession level since 2003, and appears to be growing in line with the pre-pandemic trend. Growth in the number of hours people work has slowed, but output has been stable, meaning people are accomplishing more in less time. This productivity boom means that as workers become more efficient, companies can give employees raises without having to turn around and pass the increased labor costs on to consumers in the form of price increases.

While it is slowing the labor market, it is not enough to cause unemployment panic. The Report on jobs in October — with the economy adding just 150,000 jobs and unemployment ticking up to 3.9% — was disappointing. Particularly noticeably, unemployment has increased by half a percentage point during the past six months. The rise in unemployment is close triggering the Sahm rule, which says the economy is in recession when the average unemployment rate over the previous three months is half a percentage point above its previous 12-month low. The current three-month average is 3.8%, a meaningful one up from a low of 3.5% in April but not high enough to reach the 4% average needed to trigger the rule.

But the labor market is not all bad news. Over the past three months, average hourly earnings for all employees rose 3.2% — a strong number for American workers that is broadly in line with the Fed’s long-term inflation target. It is also very likely that the latest employment report underestimated the increase in non-farm payrolls since tens of thousands of workers went on strike. (You must be at work to count as an employee.)

At the moment, I see what we are seeing in the labor market as a normalization, not a harbinger of increasingly bad news in the labor market. A simple way to show that things are still in balance is to look at Okun’s Law, a relationship between movements in the unemployment rate and economic activity. Using changes in domestic gross domestic product as a measure of economic activity, unemployment has been below the implicit Okun rate, suggesting that the recent uptick in unemployment is about as expected given the growth in the economy, not too hot or too cool.

Don’t rock the boat

The difficulty towards 2024 is to maintain this steady economy. Just because things look good now doesn’t mean they’re guaranteed to stay that way.

The biggest risk to our stability is that the softening of the labor market could turn into a severe downturn. The problem with unemployment is that it is nonlinear. Unemployment never goes up just a little. The historical record shows that once it rises half a percentage point, unemployment tends to rise even more. Unemployment is already above the Fed’s year-end forecast of 3.8% — the first time that has happened since March 2022. If it looked like unemployment might surpass the Fed’s end-2024 forecast of 4.1%, that would open the door to interest rate cuts relatively quickly. The Fed doesn’t think things have changed fundamentally about what constitutes a neutral economy, so any further deterioration in the labor market would be a signal that it tightened too much and needed to reverse course.

In an environment of a subdued labor market and slowing inflation, the Fed has a strong case for making surgical rate cuts — a modest recalibration of policy to keep the outlook stable. The momentum in the economy and the easing of financial conditions we’ve seen may limit the number of cuts we get, but the Fed can at least justify a modest change in policy. After all, a quick look at the Fed’s past rate-cutting record, shown in our adjacent table, suggests that the timing of the first cut would be well within the historical norm.

There are, of course, risks in the other direction: If the Fed starts cutting interest rates, it could resume activity to such an extent that inflation rears its ugly head again.

The most obvious sign that things may be moving in this direction comes from financial conditions – the signals given by investors that are implied by movements in stock prices, bond yields and mortgage rates. As of now, it appears that investors are expecting some easing from the Fed in 2024: Mortgage rates are falling, stock prices have jumped and corporate credit spreads have tightened. This is OK given the slowdown in inflation we have seen. But a faster acceleration in asset prices leading to rising inflation expectations could be a problem. Fortunately, we’re not there yet.

What has changed for me

While there are risks that could disrupt our economic equilibrium, the chances of a calm 2024 become more real with each data release. Sure, the economy is likely to slow down, but after a strong third quarter, some slowdown was inevitable. It is important not to get carried away and take a sober view of the bigger picture. The economy is still growing above 2%, and that’s likely enough to keep unemployment from rising enough to squeeze people’s incomes.

As I think through the scenarios for the coming year, I will say that what has changed for me is that the odds of surgical rate cuts by the Fed have increased (in my estimation, this possibility has moved from a 30% chance of happening to 50%) , while the odds of further increases next year have decreased (50% to 30%). And the likelihood of a more aggressive easing cycle to combat a broader slowdown has remained unchanged (20%). Obviously these are very subjective probabilities. But I’m not inclined to see an aggressive easing cycle because I think the risk of recession is still low: real incomes are rising, household balance sheets are strong, other central banks around the world have already started easing (probably supporting growth) and the government is on expansionary fiscal policy .

While there are risks that could disrupt our economic equilibrium, the chances of a calm 2024 become more real with each 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 nirvana-like situation for stocks. Although share prices have already risen, many stocks have underperformed the broader market. If the Fed does indeed cut rates next year, it could provide a boost to some of these laggards.

Anyway, the economy and markets have been quite the whirlwind this year – from recession to no landing, from no landing to hard landing. You can liken the economy to a matrix of growth and inflation: deflationary rise, moderate growth and good inflation, inflationary boom and stagflation. At the moment, it is clear that the odds for continued growth together with declining inflation are increasing.

Neil Dutta is CFO at Renaissance Macro Research.

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