For the last 18 months, all you’ve heard from the markets is that the U.S. economy is three months away from a recession. Now, the popular analysis is that that inflation is on a smooth glidepath down and the economy will never have a downturn again.
Worries about a recession have evaporated, and all the talk is about a “soft landing,” with the Federal Reserve not having to hike interest rates more than once more, at most.
But behind the scenes, in some economic circles, there is growing concern about another risk for the economy, dubbed a “no landing” scenario.
What does “no landing” mean? Essentially it’s marked by economic growth that’s too strong to allow inflation to fall all the way to 2%, where the Federal Reserve aims for it to be, and therefore an economy that will need more Fed rate hikes, according to Chris Low, chief economist at FHN Financial.
So instead of the U.S. central bank starting to cut rates early next year, there may be more rate hikes in store.
“There is still considerable work to do before the inflation beast is fully tamed,” Low said.
Former Fed Vice Chair Richard Clarida described the risk in crystal-clear terms. “If the Fed finds itself in March 2024 with an unemployment rate of 4% and an inflation rate of 4% with some of that temporary good news behind them, they are in a very tough spot,” Clarida said in a recent interview with Bloomberg News.
“It is a risk. It is not the base case. But if I was still there [at the Fed], I would be assessing it,” he added.
So why does this matter? Why would the Fed be in such a tough spot? Two words: presidential election.
A Fed that is dedicated to bringing inflation down might have to slam the brakes on the economy forcefully to get the job done. That gets tough during an election year, especially one that already seems poised to be filled with acrimony.
“The Fed does not play politics with monetary policy. The FOMC will do what is right for the economy, election year or not. Nevertheless, FOMC participants are already sensitive to triggering a recession. Doing it in an overt way when Congress, a third of the Senate, and the White House are up for grabs would be reckless,” Low said.
Andrew Levin, professor of economics at Dartmouth College and a former top Fed staffer, said “raising interest rates sharply in the midst of an election cycle could be a delicate matter. Even the vaunted inflation fighter, Paul Volcker [the Fed’s chairman from 1979 to 1987], decided to ease off the brakes midway through the 1980 presidential campaign.”
Ray Fair, a Yale economics professor, thinks that, whether or not the Fed successfully lowers consumer-price inflation to the vicinity of 2% will be what really matters for the 2024 presidential election. If inflation does not go gently and the Fed is still fighting next year, it would likely be negative for President Joe Biden and the Democratic Party, he said.
To avoid hiking rates next year, the Fed, in Low’s view, will raise interest rates to 6% by the end of this year. That is an out-of-consensus call. Financial markets think the Fed is done hiking with its benchmark policy interest rate in a range of 5.25% to 5.5%.
Many economist and the financial markets are talking more about prospective Fed rate cuts in early 2024 than any more hikes.
Asked during a recent radio interview if he thought a “no landing” scenario was taking shape, Philadelphia Fed President Patrick Harker replied: “I don’t think so.”
Harker said the economy was likely on track to return to the low-interest-rate and low-inflation environment of 2012-19.
“I think about this a lot, and I asked myself what’s different fundamentally about the U.S. economy now then the way it was before the pandemic,” Harker said. He concluded that there wasn’t much difference.
The big trend Harker mentioned was demographics, with baby boomers still moving in large numbers into retirement. “I don’t think we have to stay in a high-inflation regime. I think we can get back to where we were,” he said.
Steve Blitz, chief U.S. economist at research firm GlobalData.TSLombard, said he puts the probability of a “no landing” scenario at about 35%.
Blitz added it was a common mistake for economists, policy makers, traders and journalists “to presume that the expansion to come is going to look like the expansion that was.”
“At least in the United States, that was never the case,” he added.
Blitz said that if the U.S. economy were growing at a rate below 2% with an inflation rate higher than 3%, the Fed would have to raise the policy rate to about 6.5%. But if the economy is humming along with 3% growth and inflation over 3%, that would be a trickier spot. “Does the Fed really want to slow that down?” he asked.
The range of possible outcomes for the economy remains wide. Some economists still believe that a recession early next is the most likely outcome.
Other economists, like Michelle Meyer, chief U.S. economist at Mastercard, think the economy will continue to grow, with inflation coming down. Meyer described that outcome as “a soft landing with bumps.”
Stephen Stanley, chief economist at Santander U.S., said he thinks the U.S. economy will “muddle through” next year with subpar growth in the range of 1% for several quarters and inflation slowing gradually.
“Obviously, that optimism melts away if we’re back to readings of 0.4% and 0.5% on core CPI in three months or six months,” Stanley said.
Economic calendar: See what’s on the U.S. economic-data docket in the coming week