With inflation falling, unemployment low and the Federal Reserve signaling it could soon begin cutting interest rates, forecasters are becoming increasingly optimistic that the U.S. economy could avoid a recession.
Wells Fargo last week became the latest major bank to predict that the economy will hit a soft landing, slowing gently rather than coming to a screeching halt. The bank's economists had been forecasting a recession since mid-2022.
However, if forecasters were wrong when they predicted a recession last year, they could be wrong again, this time in the opposite direction. The risks that economists have highlighted in 2023 have not gone away, and recent economic data, while still mostly positive, suggests some cracks beneath the surface.
In fact, on the same day that Wells Fargo withdrew its recession forecast, Wells Fargo economists also released a report that pointed to signs of weakness in the labor market. They noted that hiring has declined and only a few industries account for much of the recent employment growth. Layoffs remain low, but workers who lose their jobs have a harder time finding new ones.
“We’re not out of the woods yet,” said Sarah House, an author of the report. “We still believe the risk of recession remains elevated.”
Ms. House and other economists have stressed that there are good reasons for their recent optimism. The economy has weathered the rapid rise in interest rates much better than most forecasters had expected. And the surprisingly sharp slowdown in inflation has given policymakers more leeway – if unemployment starts to rise, for example, the Fed could cut interest rates to try to extend the recovery.
If a recession actually occurs, economists say there are three main reasons for it:
1. The delayed slowdown
The main reason economists predicted a recession last year is because they expected the Fed to trigger a recession.
Fed officials have tried to curb inflation over the past two years by raising interest rates at the fastest rate in decades. The goal was to curb demand just enough to reduce inflation, but not so much that companies would begin mass layoffs. Most forecasters – including many within the central bank – believed that such careful calibration would prove too difficult and that a recession was all but inevitable once consumers and businesses backed off.
It's still possible that their analysis was correct and just the timing was wrong. The impact of higher interest rates takes time to ripple through the economy, and there are reasons the process could be slower than usual this time.
For example, many companies refinanced their debts during the low interest rates in 2020 and 2021; Only when they have to refinance again will they feel the higher loan costs. Many families were able to avoid higher interest rates because they had accumulated savings or paid off debts at the start of the pandemic.
However, these buffers are eroding. By most estimates, extra savings are dwindling or have already been depleted, and credit card borrowing is at record levels. Higher mortgage rates have slowed the real estate market. Student loan payments, suspended for years during the pandemic, have resumed. State and local governments are cutting their budgets as federal aid expires and tax revenues decline.
“If you look at all the support that consumers have received, a lot of it is disappearing,” said Dana M. Peterson, chief economist at the Conference Board.
Manufacturing and housing have already experienced recessions, with manufacturing declining, Ms. Peterson said, and overall business investment lagging. Consumers are the last pillar of recovery. If the job market weakens even a little bit, she added, “maybe that would wake people up and make them think, 'Well, I might not get fired, but maybe I'll get fired, and at least I won't get that big.' become.' Bonus'” and reduce their expenses accordingly.
2. The return of inflation
The main reason economists have become more optimistic about the possibility of a soft landing is the rapid slowdown in inflation. By some short-term measures, inflation is now barely above the Fed's long-term target of 2 percent; In fact, prices for some physical goods such as furniture and used cars are falling.
When inflation is under control, policymakers have more room to maneuver and can, for example, lower interest rates when unemployment begins to rise. Fed officials have already indicated they expect to begin cutting interest rates sometime this year to keep the recovery on track.
However, if inflation rises again, policymakers could find themselves in a difficult position, unable to cut interest rates if the economy loses momentum. Or worse, they could even be forced to consider raising 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 top positions at the International Monetary Fund and the Reserve Bank of India. “The question now is, will we be so lucky in the future?”
Inflation fell in 2023 partly because the supply side of the economy improved significantly: supply chains largely normalized after the disruptions caused by the pandemic. The economy also saw an influx of workers as immigration increased again and Americans returned to the job market. That meant companies could get the materials and labor they needed to meet demand without raising prices as much.
However, few people expect a similar revival in supply in 2024. This means that a further decline in inflation may require a slowdown in demand. This could be particularly true in the services sector, where prices tend to be more closely linked to wages – and where wage growth has remained relatively strong due to demand for labor.
The financial markets could also make the Fed's work more difficult. Both stock and bond markets rallied late last year, which could effectively undo some of the Fed's efforts by making investors feel richer and allowing companies to borrow cheaper. That could help the economy in the short term, but it forces the Fed to be more aggressive and increases the risk of a recession down the road.
“If we do not keep financial conditions sufficiently tight, inflation risks rising again and erasing the progress we have made,” Lorie K. Logan, president of the Federal Reserve Bank of Dallas, warned in a speech this month at an annual conference for economists in San Antonio. Therefore, the Fed should leave open the possibility of another rate hike, she said.
3. The unwelcome surprise
The economy experienced some strokes of luck last year. China's weak recovery helped keep commodity prices under control, which helped slow U.S. inflation. Congress avoided a government shutdown and resolved a debt ceiling standoff 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 the luck will continue in 2024. The escalating war in the Middle East is disrupting shipping lanes in the Red Sea. Congress faces another federal funding deadline in March after passing a stopgap bill on Thursday. And new threats could emerge: a deadlier strain of coronavirus, a conflict in the Taiwan Strait, a crisis in a previously unknown part of the financial system.
Any of these possibilities could disrupt the Fed's desired equilibrium by causing a rise in inflation or a collapse in demand – or both at the same time.
“This is what keeps you up at night as a central banker,” said Karen Dynan, a Harvard economist and former Treasury Department official.
While such risks always exist, the Fed has little room for error. The economy has slowed significantly, leaving fewer buffers in the event of a further decline in growth. But with inflation still high – and memories of high inflation still fresh – it could be difficult for the Fed to ignore even a temporary rise in prices.
“There is the possibility of a mistake on both sides that would ultimately lead to job losses,” Ms. Dynan said. “The risks are certainly more balanced than they were a year ago, but I don't think that gives decision makers much more comfort.”
Audio produced by Patricia Sulbarán.