Soft Landing? – an update
Can the Federal Reserve engineer a soft landing? I posed this question in my cover letter at the beginning of August last year and argued that such an outcome was possible. By definition, a soft-landing requires the Fed to get inflation under control without seriously slowing economic activity. Moving into 2024, it is an appropriate time to revisit this question and consider the outlook moving forward. As is always the case, given the unpredictability of markets, one must recognize that such outlooks are imprecise at best.
Looking back to 2023, one clear observation is that the nature of the current environment has generated significant uncertainty and volatility. In January’s issue of Partner Talk, Paul Snitzer reviewed the performance of the markets last year in light of the economic and geopolitical setting. He noted the presence of substantial volatility. In the last half of the year, the markets dropped significantly from August through October and then rebounded nicely in November and December. As we close out January, the presence of significant uncertainty has continued. The stock market did eke out a gain near 2 percent but the bond market has declined marginally.
Looking forward, there continues to be concern about markets and the economy as a whole. The central theme of much of the discussion about the market is what the Federal Reserve will do as far as changes to the Fed funds rate in the coming months. With the level of inflation moving towards the Fed’s target of two percent and a slowly growing economy, there is wide agreement that the next rate change will be a reduction. At its January meeting, the Fed signaled that reductions in the Fed funds rate are likely. However, there is not a consensus with respect to the timing of the start of these cuts. While some believe that the first cut should be in March, Federal Reserve Chairman Jerome Powell made it clear at his January press conference that is unlikely timing. He emphasized that the Fed wants to be sure that the inflation target is met. Other members of the FOMC1Federal Open Market Committee. have also publicly suggested that the Fed should wait longer to be sure inflation is under control. Beyond the timing of the first cut, there are also questions of the number of cuts that will be needed to keep the economy strong.
As Powell acknowledged, inflation is still well above the target 2 percent level. For the calendar year 2023, the rate of inflation as measured by the CPI2Consumers Price Index. for all items was 3.4 percent. An additional concern is that the inflation rate excluding food and energy is higher at 3.9 percent. It is good news that the rate of inflation has been declining from the high levels of 2022, but the rate of decline has slowed down and it is uncertain when the two percent target of the Federal Reserve will be reached. What lies ahead for 2024 is currently an issue of debate. There is significant variation in forecasts going forward, but the consensus is that the target will not be met until later in 2024 if at all.
The preceding discussion employs the consumers price index as a measure of inflation. The choice of this measure is a common one among both the financial press and economists. However, it is noteworthy that the FOMC focuses on inflation as measured by the PCE3Personal Consumption Expenditures. price index not the CPI. The Fed argues that the PCE price index more accurately reflects consumer price inflation4See, for example, “Presidents Message: CPI vs. PCE Inflation: Choosing a Standard Measure,” by James Bullard, The Regional Economist, Federal Reserve Bank of St. Louis, July 2013. and prefers to use that index to assess if the 2 percent target is being achieved. With the PCE Index, the rate of inflation for 2023 is 2.6 percent – much closer to the Fed’s target. And, looking back six months, the PCE inflation measure meets the 2 percent target at an annualized rate.
An alternative forward-looking measure can be obtained from the government bond market using Treasury Inflation Protected Securities (TIPS). Using TIPS, the bond market does reflect a moderating view of inflation. The annual breakeven inflation rate is currently 2.19 percent for 10 years and 2.17 percent for 5 years. These breakeven inflation numbers are much lower than backward looking CPI readings.
Given price stability is one of the mandates of the Fed, inflation expectations are a key input feeding into the future action of the FOMC. Considering the PCE price index trend and readings from the bond market, the inflation target is within reach. Given this, the need for the Fed to maintain a high Fed funds rate is limited.
The other mandate of the Fed is to achieve maximum employment. Given recent employment reports, there currently are only minor concerns on that front. The employment report for January was released on February 2. Total nonfarm payroll employment increased by 353,000 in January, and the unemployment rate stayed steady at 3.7 percent. The payroll increase, based on the U.S.
Bureau of Labor Statistics, was well above consensus expectations of 185,000. One minor concern is that the strong jobs market can lead to upward pressure on wages and inflation. In January, average hourly wages did increase by 4.5 percent over January 2023. However, with productivity gains, the entire wage increase need not contribute to higher inflation.
Beyond the Fed mandates, positive economic growth and reasonable corporate earnings are important contributors to a soft landing. Economic growth as measured by GDP increased at an annual real rate of 2.5 percent for the calendar year 2023. Looking forward to 2024, growth is expected to moderate. Most forecasts for real GDP growth in 2024 fall in the one to two percent range. (The median forecast of the FOMC members is 1.4 percent.) There is a concern that current geopolitical considerations may also further slow economic growth but a recession is not anticipated.
Corporate earnings are expected to increase by only 0.2 percent in calendar year 2023 relative to 2022. But earnings growth is expected to rebound in 2024. Based on the analysis of FactSet, the calendar year 2024 forecasted growth is 11.6 percent relative to 2023. If this high level of growth is realized, it should justify current market values.
To summarize, economic growth this year is expected to be positive but small. The combination of this growth projection for GDP, growing corporate earnings, and slowing inflation support the growing consensus that a soft landing for the economy is a probable outcome. However, if inflation continues to stay above the Fed’s target, the Fed may feel it is necessary to maintain the current high Fed funds rate, leading to the possibility of a decline in economic activity.
What is expected as far as the behavior of financial markets is concerned? Using common valuation measures such as the price to earnings ratio, the equity market looks fully valued. The current price to earnings ratio for the S&P500 index is 22. This value is not a major concern. It is above the long run average of 19 but it is not extreme and similar to the value over the past ten years. As previously noted, solid earnings growth should provide support for current valuations in the stock market.
Interest rates drive the value of the fixed income market and bond returns are inversely related to the direction of interest rates changes. The level of interest rates has been trending down and has stabilized over the past six months. This stability is likely to persist given the signals from the Fed. In such an environment, fixed income values should experience a positive return and a low level of volatility.
Can the Federal Reserve engineer a soft landing? The current outlook suggests it is possible – even likely. To the surprise of many, the Fed has been able to get inflation under control without seriously slowing economic activity. However, given the unpredictability of markets, investment portfolios must be continuously monitored to control risk.
