Economic Update: Set Up for a Soft Landing?
It’s been two years since the Federal Reserve began raising interest rates to restore price stability and bring inflation back to its preferred level of 2%. Earlier this month, Fed Chairman Jerome Powell said he can finally see light at the end of the tunnel. Now, the Fed is talking openly about cutting interest rates. When those rate cuts begin and by how much depends on inflation.
Interest rates and taming inflation
Inflation has fallen rapidly since the peaks we saw in 2022, but the road to a steady rate of 2% will be bumpy. That’s because the Fed follows two key inflation measures—the consumer price index (CPI) and the personal consumption expenditures (PCE) price index—and the current discrepancy between the two indices is much wider than historical trends.
The Fed is trying to understand what’s driving that gap. Given that Powell has already said the Fed won’t cut rates in March, the earliest they’ll consider it is in May. We expect the Fed to make four rate cuts after its regularly scheduled meetings during the second half of this year, then slow the pace to once a quarter as inflation continues to grind down.
Along with inflationary measures, the Fed will also consider financial conditions, which include things like stock markets. February has already seen the Dow Jones Industrial Average and the S&P 500 reach record highs. This also bodes well for a so-called “soft landing” of taming inflation without triggering a recession.
We believe financial conditions have gotten to the point where over the long haul, they’ll provide a little bit of a tailwind. After a 525-basis point increase in interest rates, we have an unemployment rate that remains historically low. That tells you there’s plenty of resiliency in the economy, and that the Fed may achieve their goal of a soft landing.
Labor gains
That resiliency is most profound in the labor market. Demand for labor had been greatly exceeding supply, driving wages higher. But supply is finally starting to catch up while demand is starting to stabilize. Meanwhile, productivity growth has started to pick up. Fourth-quarter nonfarm business productivity expanded at a 2.7% rate
from the prior year.
With broad wage growth of 5%, 2.7% growth in productivity means unit labor costs are quite subdued at 2.3%. These kind of cost increases are consistent with getting inflation closer to 2% and keeping it there over the long haul, which makes the Fed feel more comfortable that they can start contemplating rate cuts.
Somewhat paradoxically, labor shortages are what’s driving those productivity gains. That’s because tight labor conditions mean businesses must invest in automation and artificial intelligence to generate higher productivity. The fact that businesses have been making these kinds of investments in the face of rising interest rates speaks volumes about how critical companies believe this technology will be in the long term.
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Michael Gregory, CFA
Deputy Chief Economist & Managing Director
Michael is part of the team responsible for forecasting and analyzing the North American economy and financial markets. He has spent his career working in either ec…(..)
View Full Profile >It’s been two years since the Federal Reserve began raising interest rates to restore price stability and bring inflation back to its preferred level of 2%. Earlier this month, Fed Chairman Jerome Powell said he can finally see light at the end of the tunnel. Now, the Fed is talking openly about cutting interest rates. When those rate cuts begin and by how much depends on inflation.
Interest rates and taming inflation
Inflation has fallen rapidly since the peaks we saw in 2022, but the road to a steady rate of 2% will be bumpy. That’s because the Fed follows two key inflation measures—the consumer price index (CPI) and the personal consumption expenditures (PCE) price index—and the current discrepancy between the two indices is much wider than historical trends.
The Fed is trying to understand what’s driving that gap. Given that Powell has already said the Fed won’t cut rates in March, the earliest they’ll consider it is in May. We expect the Fed to make four rate cuts after its regularly scheduled meetings during the second half of this year, then slow the pace to once a quarter as inflation continues to grind down.
Along with inflationary measures, the Fed will also consider financial conditions, which include things like stock markets. February has already seen the Dow Jones Industrial Average and the S&P 500 reach record highs. This also bodes well for a so-called “soft landing” of taming inflation without triggering a recession.
We believe financial conditions have gotten to the point where over the long haul, they’ll provide a little bit of a tailwind. After a 525-basis point increase in interest rates, we have an unemployment rate that remains historically low. That tells you there’s plenty of resiliency in the economy, and that the Fed may achieve their goal of a soft landing.
Labor gains
That resiliency is most profound in the labor market. Demand for labor had been greatly exceeding supply, driving wages higher. But supply is finally starting to catch up while demand is starting to stabilize. Meanwhile, productivity growth has started to pick up. Fourth-quarter nonfarm business productivity expanded at a 2.7% rate from the prior year.
With broad wage growth of 5%, 2.7% growth in productivity means unit labor costs are quite subdued at 2.3%. These kind of cost increases are consistent with getting inflation closer to 2% and keeping it there over the long haul, which makes the Fed feel more comfortable that they can start contemplating rate cuts.
Somewhat paradoxically, labor shortages are what’s driving those productivity gains. That’s because tight labor conditions mean businesses must invest in automation and artificial intelligence to generate higher productivity. The fact that businesses have been making these kinds of investments in the face of rising interest rates speaks volumes about how critical companies believe this technology will be in the long term.
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