We’ve dealt with a lot of market pain this year in the Fed’s crusade against inflation.
Now, the economy seems to be teetering on the brink, and Wall Street sees a recession next year as a foregone conclusion.
It doesn’t have to be this way, though. There’s still a chance the Fed can successfully bring down inflation without significant harm to the economy — a “soft landing,” in both economist and pilot speak. Fed chair Jay Powell even said so last week: there’s a small chance, but there’s still a chance. And frankly, markets are starting to believe him, especially after an encouraging inflation report.
So what would a soft landing look like these days?
Three scenarios to think about:
1) The job market stays strong as the Fed gets inflation under control
The Fed has been hammering the job market in order to manage inflation. Makes sense: if your main source of income is gone, you’re probably going to spend less money. Because of this, we’ve all been hyper focused on the unemployment rate, which could shoot up if layoffs increase.
Thankfully, there may be a situation in which the labor market doesn’t have to suffer as much as we think.
How could this happen? Instead of achieving balance through lower demand and layoffs, we could theoretically see labor supply pick up enough to absorb job openings and temper wage growth. People are voluntarily quitting their jobs at a historic pace and companies are willing to pay up for new employees. Cool the market down, and you could find a sweet spot where companies aren’t hiring, but they aren’t exactly firing either. The key here is wages: higher paychecks can lead to spiraling costs for businesses, and consequently, higher prices.
Will it actually happen? It’s possible. We’d have to find a way to bring more people back into the workforce or force companies to pare back on hiring just enough to get wages in check. Easier said than done. The Fed has hiked without upending the job market before — most recently in the mid-1990s — but it also wasn’t contending with 8% inflation and adjusting rates aggressively higher.
For what it’s worth, Powell explicitly mentioned last week that the job market could soften without roiling unemployment. A gridlocked Congress makes this tougher, though. Congress could provide targeted stimulus to help supply or keep company workforces afloat. But that can only happen if lawmakers are able to find common ground.
2) Inflation subsides without a huge drop in earnings
Who controls inflation? The Fed and corporate America.
Those prices you pay for goods and services? From a company’s view, they move up and down based on supply, demand, expense management, risk and a whole load of other factors.
We’ve talked about the job market part of the equation, but there could be a scenario in which supply and demand even out enough to subdue inflation.
How could this happen? This bout of inflation appeared because of soaring raw material and shipping costs and an American consumer who was willing and able to pay higher prices. Supply chains are healing, so costs are coming back in check and goods inflation is slowing down. Services inflation — rent, medical bills, education, etc. — is still fiery hot, but it looks to be cooling off ever. That could eventually bleed into spending and corporate profits, but not enough to force a panic.
Will it actually happen? Actually, it may already be happening. Real-time measures of rent prices are starting to slip, and profit margins for services sectors are expected to shrink over the next 12 months — presumably because demand is softening. Earnings are still holding strong, even though Wall Street 12-month forward profit estimates have slipped about 3% since July. That’s not good, but it’s a far cry from the 10 to 40% drops in profit we’ve seen in past recessions.
Of course, this all depends on how much more pain the Fed is willing to invoke. Powell has said that rates could stay high for a while, and he could risk pushing demand too far in the other direction.
3) Markets manifest a soft landing
With inflation, perception is almost as good as reality. If people expect inflation to stay high, they change their spending habits to match that, pushing up inflation. It’s a vicious cycle, and this is what the Fed is trying to avoid.
Luckily, we don’t seem to be at that point yet. Up until now, market-implied inflation expectations from two to five years out have stayed surprisingly low. This has been a key difference between today and the 1970s inflation crisis: we believe the Fed can pull it off this time. And now, with markets holding their ground, the Fed may have more runway than it thinks.
How could this happen? Inflation keeps moving down and it eventually converges with expectations. At the same time, the job market and earnings stay as resilient as they’ve been, buying time for inflation’s trend to turn. Eventually, the economy emerges relatively unscathed.
Will it actually happen? Depends on the vibes. Stocks don’t seem to be expecting a recession, but that could change with one bad headline. I mean, the Dow just clocked its strongest monthly gain since the 1970s. That’s not something you normally see when the economy is in decline. Strong job market and earnings data could be buying the Fed time, but it’s hard to say how much longer people can trust the Fed to steer the plane.
A soft landing isn’t out of the question yet, and it could get harder to achieve as we fly further into the storm.
But like Powell said, there may still be a chance. Don’t forget that.
*Data sourced through Bloomberg. Can be made available upon request.