Signs of a soft landing are emerging

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About the Author: Joseph E. Gagnon is a senior fellow at the Peterson Institute for International Economics and a former head of the Federal Reserve.

The coming recession could be the most widely predicted recession in US history. In the past, forecasters often didn’t realize we were in a recession until months after it started. But professional forecasters polled in October expected the unemployment rate to rise by 0.6 percentage points in 2023, to 4.3% from 3.7% this year. This suggests that a recession is likely according to a rule promoted by economist Claudia Sahm, who found that increases in the unemployment rate of at least 0.5 percentage points almost always signal recessions.

A rise in unemployment to below 5% would be the mildest recession in post-war US history. Can the Fed achieve what is essentially a soft landing? And will that be enough to calm high inflation?

A good omen is that there does not appear to be any dangerous excess in housing or business investment. Thanks to pandemic relief programs, households have large savings buffers. The coming slowdown is mainly due to Fed interest rate hikes aimed at discouraging spending. Given the lags and uncertainties about the impact of interest rates on the economy, there is an undeniable risk that the Fed is overdoing it. President Jerome Powell acknowledged this risk at the press conference after the November policy meeting. But the Fed is anticipating what could be described as a very mild recession or a slowdown that doesn’t quite reach the norm of a recession.

Probably the most frustrating fact for the Fed is that its rate hikes so far have had little effect on the strong labor market, with continued rapid job gains and no significant increase in the unemployment rate. It will take a significant rise in the unemployment rate, combined with a decline in job vacancies, to dampen wage growth.

The Fed believes that a 4% unemployment rate is consistent with its long-term inflation targets. However, there is reason to believe that the aftermath of Covid-19 has temporarily raised this equilibrium rate to between 4% and 5%. Thus, an unemployment rate of around 4.5% may be necessary for a gradual decline in the pace of wage growth. A key condition for moderating wage growth is that headline inflation must fall rapidly towards the 2% target in order to keep the long-term inflation expectations of businesses and workers firmly anchored, as they have been so far.

Wages, measured by the employment cost index, are rising at a rate of 5%, down slightly from the start of the year. In the long term, wage growth must settle at a rate of 3% to be compatible with the Fed’s inflation target. But in the short term, only a modest reduction in wage growth to 4% or 4.5% may be needed to bring inflation down sharply due to likely favorable developments in non-labour costs .

Two forces seem to be at work. First, commodity futures markets show energy and grain prices falling over the next two years, while metal prices remain flat. If the markets are right, raw material costs will fall, allowing companies to pay workers more without raising prices.

Second, the shift in pandemic consumer demand from services to durable goods has caused durable goods prices to rise faster than wages for the first time in decades. With the structure of demand returning to normal, the long-standing trend of goods prices rising more slowly than wages is likely to reassert itself. Even a partial return to this long-term trend would significantly reduce headline inflation. For example, new and used car prices have jumped much faster than autoworker wages in 2021. As the chip shortage eases and car production increases, we are likely to see car prices rise more slowly than wages (or even fall) over the period. next two years. The Manheim Used Car Price Index is already down from its peak at the start of the year.

If these significant reductions in cost pressures persist, inflation could decline from 7% in mid-2022 to 3% by the end of 2023 and even lower in 2024, despite wage growth of 4% or more. The rapid reduction in inflation allows the Fed to be patient in bringing wage growth back to its long-term level.

To get this good result, the Fed might only need to raise interest rates by another percentage point, to around 5%, as the market currently expects by the start of the month. next year. It is possible that we can avoid a recession, but it is more likely that we will have a very mild recession, with unemployment only reaching around 4.5% for a few years. Although this is the most likely outcome, and the one expected by financial markets and forecasters, it must be said that there is a greater risk that unemployment will exceed 5% than it will remain below 4%.

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