A 'Soft Landing' From the Fed is Expected, but It's Not a Sure Thing

U.S. Federal Reserve Chair Jerome Powell is laying the groundwork for a controlled economic slowdown, aiming to guide financial markets through potential turbulence. His recent testimony before Congress hinted at the possibility of the central bank initiating interest rate reductions in the near future.

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Powell's cautious optimism aligns with the prevailing sentiment among economic experts. According to the latest survey by The Wall Street Journal, forecasts indicate a gradual easing of GDP growth to approximately 1% in the second and third quarters of this year, with inflation also expected to gradually taper off to around 2% by the fourth quarter.

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Although this scenario suggests a period of subdued growth without plunging into recession, and with inflation hovering around the target rate of 2%, it represents what economists refer to as a "soft landing."

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The financial community is lauding the foresight of a select group of economists who anticipated this trajectory early on. However, the trade-off between growth and inflation may not be as favorable as initially perceived, and inflation could still present challenges.

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As 2023 commenced, many economists sounded alarms about the looming specter of recession in the U.S. Yet, contrary to these warnings, GDP growth for the year reached 2.5%, while unemployment remained below 4%.

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In the lead-up to the release of fourth-quarter 2023 GDP figures, forecasts from The Wall Street Journal's panel of experts predicted a growth rate of 1.7%. However, the actual figure turned out to be significantly higher at 3.4%, highlighting a substantial forecasting error.

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The question arises: how did so many highly educated economists miss the mark? Can we place our trust in the Federal Reserve's optimism, now dubbed "Team Soft Landing," after previously labeling it "Team Transitory"?

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The truth is, the trajectory of growth and inflation remains uncertain, and Powell's confidence in an imminent rate cut could set the stage for painful adjustments if conditions take an unexpected turn.

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Market expectations are now leaning towards a rate cut by June based on Powell's remarks. However, if circumstances force him to retract this stance, as was the case with the underestimated persistence of inflation, it could lead to a stock market downturn and potentially push the economy into recession.

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The root of the issue lies in the unparalleled nature of the pandemic-induced recession and subsequent recovery. Governments, both domestically and abroad, deliberately halted economic activity and implemented substantial relief measures, resulting in an unprecedented economic environment.

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During the lockdown, households had limited spending opportunities, leading to increased savings. Even after the economy reopened, consumer spending was prolonged by unused credit card balances, extending the recovery beyond economists' expectations.

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Despite rising consumer debt and slight increases in loan delinquencies, overall household debt remains relatively low compared to historical levels. However, with limited spending outlets, consumer demand is driving up prices across various sectors, such as dining out, where menu prices have surged significantly.

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To gauge inflationary pressures, the Federal Reserve closely monitors the Personal Consumption Expenditures (PCE) Price Index. The latest data for February revealed an annualized monthly price increase of 4.1%, with a slightly lower figure of 3.2% when excluding food and energy.

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While the labor market has cooled slightly, it remains tight, with 1.4 job openings for every unemployed individual. Monetary policy currently maintains a neutral stance, with the Fed estimating that an inflation-adjusted interest rate of 0.5% would neither stimulate growth nor fuel inflation. However, some argue this threshold has risen to around 2%.

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Considering that long-term credit instruments like mortgages and corporate bonds are priced off the 10-year U.S. Treasury rate, which is above 4%, the real interest rate remains below 2%. With core inflation hovering around 3%, Powell's contemplation of rate cuts presents a considerable risk.

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In summary, while the concept of a soft landing is desirable, its realization is far from assured in the current economic landscape.

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