The economy proved resilient in the recent quarter, despite the effects of rising interest rates implemented by the Federal Reserve. The Fed is trying to orchestrate a “soft landing” by bringing inflation under control without triggering a recession. This is no easy task. In charting their course, the Fed is “navigating by the stars under cloudy skies,” as one pundit observed recently. Interest rates are now at the highest level in twenty-two years, and consumers are feeling the pinch. Yet, there is some reason for optimism regarding the interest rate outlook. At the September meeting, Fed officials voted not to raise rates, instead keeping their target at 5.50%. We believe the Fed is unlikely to hike rates again this year. Instead, it is more likely they will pause and keep rates elevated into next year while watching to see the impact on inflation. They want to be sure inflation is under control, even if they must sacrifice growth to be certain.
To date, the soft-landing scenario is playing out. The economy grew at a 2.4% annualized rate in the second quarter, a slight acceleration from the previous quarter’s 2.0% pace. Consumption grew at a modest 1.6%, which was better than expected. Business spending grew a healthy 7.7%. We expect growth to slow in the coming quarters as the lagging effect of higher rates takes hold. The Fed was slow to increase rates as inflation peaked, and it will likely be slow to cut rates as inflation falls. For this reason, we see some risk of overtightening, leading to a recession next year. If a recession does occur next year, we think it would likely be a mild recession, not a severe or sustained downturn. The greater risk to growth would be a resurgence of inflationary pressures. We think this scenario is likely only if some unanticipated shock occurs – such as higher oil prices or supply chain disruptions related to geopolitical events.
We are also watching the outlook for employment as a key indicator of where the economy is headed. As the Fed keeps up the pressure, the labor market is softening. The August jobs report showed nonfarm payrolls rose by a stronger than expected 187,000. However, revisions to prior estimates cut 110,000 jobs for the last two months, suggesting a slowdown in hiring. The August jobs report also showed a large increase in the labor force, pushing the unemployment rate higher to 3.8% (i.e. more people entered the labor force who are looking for jobs), while wage growth was below expectations. Ideally, a more balanced labor market and easing wage pressures will allow inflation to move lower, reducing the need for the Fed to raise interest rates further.
Though we remain fairly optimistic, there are several other risks worth watching. Domestically, the threat of an extended strike by the United Auto Workers and a renewed activism of unions in other industries illustrates broad unrest over wages and could also have an impact on growth. The resumption of student loan payments on top of already high rent and food costs is another headwind. Looking abroad, stress in the real estate sector in China is causing banks to tighten lending standards into a slowing economy. The bottom line is we, too, see cloudy skies but do not anticipate an imminent downturn in the labor market and economic activity.
