By Howard Schneider
WASHINGTON (Reuters) – It took a stock market crash, a housing crash and a pandemic to kill the last three U.S. economic expansions.
But of all the risks facing a resilient economy right now, the Federal Reserve may top the list, as U.S. central bankers debate when to lower the restrictive interest rates used to beat inflation that now seems to be in steady decline.
Fed officials have signaled a coming pivot towards lower rates sometime this year to avoid pushing too hard on an economy that is outperforming expectations but which many analysts worry has become too dependent on spending by households that are showing signs of stress and on job growth in a narrow set of industries that masks otherwise-stalled hiring.
With annualized inflation running beneath the Fed’s 2% target for seven months, some formulas referred to by officials are pointing to rate cuts sooner than later. Economists, meanwhile, have begun noting the risks of the Fed either falling behind a possible slowdown or of failing to account for the chance the economy may be able to sustain faster growth and more employment than thought without a new surge in prices.
“There is still risk out there that there is a short and shallow recession” in the coming year, said Dana Peterson, the chief economist of the Conference Board. CEOs who participated in a recent survey by the business group continued to cite recession as a top risk for the year, while the board’s Leading Economic Index also points in that direction.
Some recent growth drivers, including government spending and business investment, will almost certainly ebb, Peterson said.
“What’s left? The consumer.”
In an environment where wage growth eases, pandemic-era savings get exhausted, and businesses that have hoarded workers realize labor shortages are easing, Peterson said: “Do we think consumer spending is going to slow? Yes.”
DEPENDENT ON CONFLICTING DATA
The Fed is expected to hold its benchmark overnight interest rate steady in the 5.25%-5.50% for the fourth time since July at the end of a two-day policy meeting on Wednesday. Of more note would be any signal in the Fed’s policy statement or from Fed Chair Jerome Powell in a post-meeting press conference about the timing and pace of future rate cuts.
The economy’s persistent strength in the face of “restrictive” monetary policy has struck a nerve. The S&P 500 index touched a record high last week, consumer sentiment is rebounding, President Joe Biden’s administration has hailed the progress, and usually prudent central bankers have edged close to declaring that they have nailed the hoped-for “soft landing” in which high inflation is tamed without triggering a painful recession or huge job losses.
It has also begged the question: What’s everyone missing?
“Data-dependent” policymakers say they are proceeding with caution, but the numbers have offered more conundrum than clarity, and in fact challenged some of the Fed’s basic premises.
At the start of 2023 Powell said household “pain” in the form of rising joblessness and much slower wage growth would be needed to curb high inflation. Even as that dour outlook was dropped, policymakers said a convincing “disinflation” would require a period of growth below the economy’s potential, a hard-to-estimate concept the Fed considers to be about 1.8% annually over the long run but which might vary over shorter periods.
Yet inflation has fallen even though the unemployment rate has remained little changed for two years – it was 3.7% in December – and as the economy continues to grow faster than the rate estimated as inflationary. Output expanded in the fourth quarter at a 3.3% annual pace even as inflation slowed. The Fed’s preferred inflation measure, the personal consumption expenditures price index, rose at just a 1.9% percent annualized rate from June through December.
‘AS GOOD AS IT GETS,’ THEN WHAT?
Fed Governor Christopher Waller framed the situation earlier this month as being “almost as good as it gets” for a central banker. “But will it last?,” he asked.
The current expansion’s durability, remarkable already for restoring the massive job losses seen at the start of the coronavirus pandemic in 2020 and then some, will depend in part on how the Fed’s coming policy turn plays out.
The possibilities range from a delayed impact of monetary tightening that still brings “pain” to the job market, perhaps unnecessarily given the path of inflation, to a quite opposite situation in which improvements in productivity and supply dynamics convince the Fed it can lower interest rates even if growth remains strong.
By one Fed measure, the financial conditions shaped by monetary policy are lopping about half of a percentage point annually from growth that officials already expect to slow to about 1.4% this year.
The issue now is whether the Fed can scale expected interest rate cuts to keep even that pace of growth on track given what could be developing weaknesses in the economy – from rising credit usage and defaults among households to the health of banks with loans made against devalued commercial properties.
Fed officials are adamant they won’t outstay their welcome with interest rates that remain too high for too long. Still, for now they say they see a greater error in easing prematurely and risking a resurgence of inflation, a mistake the Fed made in the 1970s and one that Powell has pledged not to repeat, than in keeping rates where they are a bit longer.
The Fed is already bucking history with the possible approach of a “soft landing” from inflation that spiked to a 40-year high in 2022, as the pandemic’s influence on global supply chains, consumer spending patterns, and hiring practices drove an economic reordering that is still underway.
Since the late 1980s, as inflation and changes in the Fed’s policy rate both became less volatile, the U.S. central bank has only gotten through one rate hiking cycle without a significant increase in the unemployment rate: 1994-1996. Doing so required a judgment, which Powell may also face, that inflation pressures were contained despite ongoing growth.
MOVING TOO SLOW?
Until rates fall this time, the jury remains out.
Luke Tilley, the chief economist at Wilmington Trust Investment Advisors, thinks the economy will skirt recession, but doesn’t rule out Powell making the opposite mistake of the 1970s-era Fed and leaving policy tighter than needed, with the real hit from two years of large rate increases still to come.
“If we are going to have a recession, that cake is baked. The lagged impact of rate hikes will hit harder than we expect,” he said. Inflation seems set to slow faster than the Fed anticipates, and with rate cuts perhaps not starting until June, “I think they’ll still have rates too high at the end of the year.”
(Reporting by Howard Schneider; Editing by Dan Burns and Paul Simao)