Hope Fades for a Soft Landing
Stubborn inflation is undermining the Federal Reserve’s ability to orchestrate a soft landing for the U.S. economy.Download PDF
Economists have long debated whether the Federal Reserve can achieve a soft landing of inflation falling to the Fed’s 2% target, with economic activity slowing but not contracting.
Yet the recent release of a strong Consumer Price Index report showed inflation remained elevated in September, and marked the latest sign the Fed may have more work to do. The Fed might have to force a recession to bring inflation to target.
Signs of softening
Key economic reports indicate that the U.S. economy has been growing steadily throughout the year, as employment growth remains healthy. Despite still elevated inflation consumers continue to spend on services, but consumption of goods has slowed.
Consumers are Buying Fewer Goods
The slowdown in goods consumption may indicate that some consumers are beginning to feel some pressures from both elevated consumer prices and the exhaustion of excess savings from the prior stimulus checks. Furthermore, U.S. consumers are becoming more reliant on credit card spending; the credit card debt balance has surpassed $1 trillion. This is particularly troubling since interest rates on credit cards have spiked beyond 20%.
Credit card rates surpass 20%
Proponents of a soft-landing scenario base their arguments on the healthy labor market and continued consumer spending to support growth in the U.S. However, we are beginning to see some challenges ahead. Beyond the exhaustion of excess savings and higher usage of credit, student loan repayments started at the beginning of the fourth quarter of 2023. Also, the United Auto Workers strike could dent the labor market as well as the overall economy.
Either way, the Fed’s rate hikes are likely to further dampen economic activity in the coming months; it just takes time for the effects to kick in. Although the Fed decided to hold rates at 5.5% during its September meeting, the Federal Open Market Committee (FOMC) meets again in November and December. It’s likely that the Fed is near the end of its rate hike cycle; however, their more hawkish tone suggests some members may prefer erring on the side of overtightening to quell inflationary pressures and expectations.
While former House Speaker Kevin McCarthy was able to avoid a government shutdown at the end of the third quarter by sacrificing his position, growing budget deficits may play a role in keeping interest rates relatively elevated. Higher deficits mean the U.S. Treasury will need to issue more bonds to cover the funding gap. Greater supply of Treasuries could lead to higher rates.
If interest rates continue to remain elevated, markets will likely face challenges. Some investors are hopeful that the Fed will begin to cut rates soon. However, this may be a low probability event unless the U.S. economy enters recession. The Fed’s continued message of interest rates remaining “higher for longer” will weigh down sentiment, as concerns over debt maturities become more worrisome.
With debt maturities coming due, some corporations will be forced to refinance at higher interest rates. This will affect sectors like commercial real estate and utilities that depend on the debt market to finance their growth. If commercial real estate defaults continue to rise, regional banks will be vulnerable as they generally have more exposure to the sector.
A Fine Line
We continue to anticipate a slowing economy in the near future, but we do not foresee a major crisis unfolding. Markets will likely remain modestly volatile until the Fed has a firm grip on inflation. As the stimulus savings become exhausted and student debt repayments continue, the Fed must walk a fine line to bring the economy back in balance. Although the Fed could raise rates again, it remains highly unlikely that it would begin cutting rates any time soon. In this environment, it seems prudent to maintain a relatively defensive allocation in large-cap stocks versus vulnerable assets like real estate and small-cap value.
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