Federal Reserve Chair Jerome Powell reckons the US economy can skirt recession. But the odds are stacked against him — thanks to banking, politics, and even the weather.
In Powell’s view, the gravity-defying strength of American labor markets — on display again in jobs data published Friday, which showed a bumper increase last month — is smoothing the way for a soft landing, even after five percentage points of interest-rate hikes in little over a year.
Still, a labor market that remains too-hot-to-handle means the Fed will have to hold rates higher for longer to quell inflation — the very reason recession risks are so high. And for Powell’s forecast to come true, the US economy will have to overcome three major obstacles, all pointing to a downturn in the second half of this year.
Driven by the combined impact of Fed tightening and bank failures, it will likely hit small businesses and commercial real estate especially hard.
Coming to a head right now, the partisan standoff threatens a period of intense financial stress. If the US government does default, the blow to the economy and markets could rival the 2008 crash.
The weather system is gathering force, threatening extreme conditions around the world that would disrupt commodity supplies, push prices higher, and keep the Fed focused on inflation.
“I don’t believe there is a good example of a ‘soft landing’ in the five or so decades that the Federal Reserve has been mostly in charge of macroeconomic policy, and don’t see why the present situation should be different,” says James Galbraith, an economics professor at the University of Texas who in 1978 worked on the legislation that enshrined the Fed’s full-employment goal.
The dynamics that lead from higher rates to a shrinking economy are straightforward. As borrowing costs climb and asset prices fall, spending slows and businesses cut jobs. For central banks, that rise in unemployment — and the resulting drag on wages — is the mechanism that brings inflation back to target.
Then came the banking scare. The wave of failures that began with Silicon Valley Bank was, in some sense, not a surprise. No one knew exactly what would break as the Fed hiked — but everyone suspected that something would.
What’s more, stresses in the banking system have a tendency to snowball. Early assurances that SVB was an extreme outlier now look wide of the mark, as contagion has spread. Taken together, bank failures in 2023 already rival those in 2008 in terms of asset size.
At his press conference, Powell called the resolution of First Republic — taken over by JPMorgan Chase & Co. last week — an “important step toward drawing a line” under the crisis. Volatility in shares of other regional lenders since then suggests the line remains dotted.
Debt Ceiling Debacle?
Treasury Secretary Janet Yellen sent a blunt warning to US lawmakers on May 1: her department’s ability to use special accounting maneuvers to stay within the debt limit could be exhausted as early as the start of June. The Treasury has been ducking and weaving to avoid default since hitting the current statutory limit of $31.4 trillion in January.
With prices rising much faster than the Fed wants, “it would not be appropriate to cut rates and we won’t cut rates,” Powell told reporters last week. Translation: If recession hits, don’t expect us to ride to the rescue with monetary stimulus.
Bloomberg Economics forecasts that rising wages, and the end of the disinflationary impulse from goods and energy, will leave core inflation stuck around 4% the end of this year. And it could be worse.
The National Oceanic and Atmospheric Administration projects a 62% chance of the extreme weather system developing between May and July, rising to 80% by the fall. A strong El Niño, as some models predict, could add to inflation.
The International Monetary Fund says strong El Niño’s can add 4 percentage points to commodity-price inflation. Add that to the mix, and the space for Fed rate cuts shrinks from small to nonexistent.
Olivier Blanchard, an economist at the Peterson Institute, took the opposite side in that debate — and says he still thinks higher unemployment is on the cards. But, Blanchard concedes that “if we continue to have a decrease in vacancies and no increase in unemployment for another couple of months, then Waller could turn out to be right.”
Other outcomes are possible. One is a “rolling recession” – where one industry after another takes a hit, but the economy as a whole never shrinks. There’s some evidence that’s what is happening, as manufacturing and real estate bottom out ahead of any significant downturn in labor markets.
Still, it’s tough to make either soft landing or rolling recession the base case.
That’s bad news for Powell’s optimistic forecast. Worse, a shallow recession might not even be enough to do the job of bringing inflation back to target. On average, past downturns have only lowered core inflation by a limited amount, and with significant lags.
Put the pieces together, and stagflation — with the economy contracting and inflation still too high — is the likeliest outcome.