The US Economy: Soft Landing or Hard Fall?

The US Economy: Soft Landing or Hard Fall?

At the end of 2022, the consensus was that there was little hope of the US avoiding a recession. The conflict in Ukraine was pushing energy prices ever higher and choking supply, making an energy-driven deep recession in Europe look almost inevitable. Inflation was still over 7%, following a spike of over 9% in June¹, and the Federal Reserve was locked in a rate-hiking balancing act to drive it down closer to its 2% target without tipping the economy into recession. A surge in the stock markets after the end of the global COVID pandemic had sent share prices rocketing through 2021 and into the start of 2022. But by the end of that year, Wall Street had experienced its worst decline since 2008².

But what a difference 12 months makes. Now, there are a growing number of observers who think that the Fed may have pulled off what it has so often failed to do before - the extremely difficult task of reigning in the economy enough to soften inflation without spurring recession.

In Europe, milder weather and fast-moving energy policy has staved off the worst impacts of tightening energy supply and rising prices. In the US, the Inflation Reduction Act early in 2023, which authorised $900 billion of spending, and the new term funding facility to ease the liquidity crunch for US regional banks in March, have boosted growth and helped offset the tightening of the Fed’s interest rate hikes. The result is that the Nasdaq and S&P500 are trading at new record highs, even as inflation has dropped to just over 3%³.

Has the Fed pulled it off?

In February, Deutsche Bank said⁴ it was no longer forecasting a US recession in 2024. It now expects the U.S. economy to grow by 1.9% this year, on a quarterly average basis, compared with its prior forecast of 0.3%.

"Though the economy continues to face several headwinds – namely, still-tight credit conditions, rising consumer delinquency rates and a slowing labor market – the resilience to date points to a more benign slowdown in 2024 than we had previously projected," said Matthew Luzzetti, the brokerage's chief US economist.

The IMF is also predicting a soft landing⁵, not just for the US, but for the global economy too. In January, Economic Counsellor and Director of Research of the IMF Pierre-Olivier Gourinchas said that forecasts for growth in a number of economies were rising while inflation was falling. However, he also warned that central banks still needed to tread lightly.

“Uncertainties remain and central banks now face two-sided risks. They must avoid premature easing that would undo many hard-earned credibility gains and lead to a rebound in inflation. But signs of strain are growing in interest rate-sensitive sectors, such as construction, and loan activity has declined markedly. It will be equally important to pivot toward monetary normalisation in time… Not doing so would jeopardise growth and risk inflation falling below target,” he said.

At a UBS event in February, Goldman Sachs chief executive David Solomon was similarly cautious. He warned¹ investors not to get too confident, cautioning that while Wall Street might be on the up, on Main Street, US consumers were still hesitant about spending.

Soft landing or hard fall?

Many believe that stocks have risen too far, too fast and even a soft landing would trigger some declines. The confidence injected into the markets by recent growth and the signs of a soft landing has already been priced in, so continued stability in employment numbers and the rate of inflation should hold the ship steady. If that confidence ran a little bit high however, or if investors are expecting faster interest rate cuts than the Fed is planning, stocks are likely to trim their gains.

Business spending and investment is also likely to be slow in a soft landing scenario. While companies won’t see any need for large cutbacks, they will still be looking to keep costs low, particularly if interest rates remain high. Firms may look for efficiencies and hold off on major investments until the outlook improves further.

In the bond market, prices and yields are shifting once again. There has been significant new Treasury and corporate debt issuance and now some investors are unwinding their rate cut bets. The bond market continues to be highly volatile compared to the period of inflation certainty, as investors’ rate expectations swing back and forth.

Bond yields spiked to their highest level in 17 years in summer 2023, with the yield on the US Treasury 10-year note reaching 5%², when investors were braced for more rate hikes. This quarter, as inflation appears to be tamed and the consensus around a soft landing grows, volatility is calming somewhat.

However, there are no certainties that there aren’t tail risks looming. There may still be a delayed impact from the Fed’s interest rate hikes, with economists looking particularly carefully at consumer spending and jobs data. Optimism may also have gone too far, and if it's not matched rapidly enough by reality, unwinding that exuberance could be the moment that pushes the US economy over the edge.

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