With inflation falling, unemployment rates falling, and the Federal Reserve signaling that it may soon begin cutting interest rates, forecasters have become increasingly optimistic that the U.S. economy can avoid a recession.
Wells Fargo last week became the latest major bank to predict that the economy will have a soft landing, gently slowing rather than stopping. Economists at the bank had been predicting a recession since mid-2022.
However, if forecasters were wrong when they predicted a recession last year, they may be wrong again, but this time in the opposite direction. The risks highlighted by economists in 2023 have not yet gone away, and recent economic data, while still mostly positive, suggest some cracks beneath the surface.
On the same day that Wells Fargo backed down from calling for a recession, its economists also published a report pointing to signs of weakness in the labor market. They note that hiring has slowed, and that only a few industries account for much of the recent job gains. Layoffs remain low, but workers who lose their jobs have difficulty finding a new job.
“We’re not out of the woods yet,” said Sarah House, the report’s author. “We continue to believe that recession risks remain high.”
Ms. House and other economists stressed that there are good reasons behind their recent optimism. The economy has been able to withstand the rapid rise in interest rates much better than most forecasters expected. The suddenly rapid slowdown in inflation has given policymakers more leeway — if unemployment starts to rise, for example, the Fed could cut interest rates in an attempt to prolong the recovery.
If a recession does arrive, economists say there are three main ways it could happen:
1. Late deceleration
The main reason economists predicted a recession last year is because they expected the Fed to cause one.
Fed officials have spent the past two years trying to rein in inflation by raising interest rates at the fastest pace in decades. The goal was to reduce demand enough to reduce inflation, but not so much that companies would lay off workers on a large scale. Most forecasters — including many within the central bank — believe that such fine calibration will be very difficult, and that once consumers and businesses start to decline, a recession will become inevitable.
It is still possible that their analysis was correct, and that it was just the timing that was wrong. It takes time for the effects of higher interest rates to trickle through the economy, and there are reasons why the process may be slower than usual this time around.
For example, many companies refinanced their debt during the period of very low interest rates in 2020 and 2021; They will only feel the pinch of higher borrowing costs when they need to refinance again. Many families have been able to ignore higher interest rates because they built savings or paid off their debt earlier in the pandemic.
However, those temporary barriers are eroding. Additional savings are dwindling or have already disappeared, by most estimates, and credit card borrowing is at record numbers. High mortgage rates have slowed the housing market. Student loan payments, which were paused for years during the pandemic, have resumed. State and local governments are cutting their budgets as federal aid dries up and tax revenues decline.
Dana M. said: “When you look at all the support that consumers have gotten, a lot of it is fading away,” said Peterson, chief economist at the Conference Board.
Ms Peterson said the manufacturing and housing sectors were already in the doldrums, with output shrinking and business investment lagging more broadly. Consumers are the last pillar holding back the recovery. She added that if the job market weakens even a little, that might wake people up and make them think: Well, I might not get fired, but I might get fired, and at least I won’t get that much money. Bonus,” and reduce their spending accordingly.
2. The return of inflation
The biggest reason economists are more optimistic about the prospect of a soft landing is the rapid deceleration of inflation. By some shorter-term measures, inflation is now barely above the Fed’s long-run target of 2%; Prices of some physical goods, such as furniture and used cars, are already falling.
If inflation is under control, that gives policymakers more room to maneuver, allowing them to cut interest rates if unemployment starts to rise, for example. Already, Fed officials have indicated that they expect to start cutting interest rates sometime this year to keep the recovery on track.
But if inflation rises again, policymakers may find themselves in an awkward position, unable to cut interest rates if the economy loses momentum. Or worse, they may have to consider raising interest rates again.
“Despite strong demand, inflation is still falling,” said Raghuram Rajan, an economist at the University of Chicago Booth School of Business who has held senior positions at the International Monetary Fund and the Reserve Bank of India. “The question now is: Will we be that lucky in the future?”
Inflation fell in 2023 partly because the supply side of the economy improved significantly: supply chains have largely returned to normal after disruptions caused by the pandemic. The economy also received an influx of workers as immigration rebounded and Americans returned to the labor market. This means companies can get the materials and labor they need to meet demand without raising prices as much.
However, few people expect a similar return to supply in 2024. This means that for inflation to continue falling, demand may be required to slow. This may be particularly true in the services sector, where prices tend to be more tightly linked to wages – and where wage growth has remained relatively strong due to demand for workers.
It is also possible that financial markets will make the Fed’s job more difficult. Stock and bond markets rose late last year, which may effectively negate some of the Fed’s efforts by making investors feel richer and allowing companies to borrow more cheaply. This may help the economy in the short term, but it forces the Fed to act more aggressively, increasing the risk of causing a future recession.
Lori K warned. Logan, president of the Federal Reserve Bank of Dallas, said this month that “if we do not maintain sufficiently tight financial conditions, there is a risk that inflation will rise again and reverse the progress we have made.” In a speech at the annual conference of economists in San Antonio. As a result, she said the Fed should leave the door open to the possibility of another interest rate increase.
3. Unwelcome surprise
The economy had some lucky breaks last year. The weak recovery in China helped keep commodity prices in check, which contributed to slowing inflation in the United States. Congress avoided a government shutdown and resolved the debt ceiling crisis with relatively little drama. The outbreak of war in the Middle East had only a modest impact on global oil prices.
There is no guarantee that luck will continue in 2024. The widening war in the Middle East is disrupting shipping lanes in the Red Sea. Congress will face another government funding deadline in March after passing a temporary spending bill on Thursday. New threats could emerge: a more deadly coronavirus strain, conflict in the Taiwan Strait, and a crisis in a previously obscure corner of the financial system.
Any of these possibilities could upset the balance the Fed is trying to achieve by causing inflation to rise or demand to collapse — or both at once.
“This is the thing that keeps you up at night if you’re a central banker,” said Karen Dinan, a Harvard economist and former Treasury Department official.
Although such risks always exist, the Fed’s margin for error is small. The economy has slowed significantly, leaving less room for protection in the event of a further hit to growth. But as inflation continues to rise – and memories of high inflation persist – the Fed may find it difficult to ignore even a temporary rise in prices.
“There is scope for error on both sides that could ultimately lead to job losses,” Ms Dinan said. “Risks are more balanced, certainly, than they were a year ago, but I don’t think that provides any more comfort to decision makers.”
Audio produced by Patricia Solbaran.