Wells Fargo report: Can Fed stick a 'soft landing?'
By the Wells Fargo Ecnomics Group
The continued resiliency of the economy and the decline in inflation has raised the probability that the Federal Reserve will be able to pull off a "soft landing."
We still think that a modest downturn in economic activity is more likely than not due to a passive tightening of policy, via rising real interest rates, in the coming months. But even if the Fed pulls off a soft landing, real GDP growth likely will be subpar in 2024.
Will the Fed Be Able to Stick the "Soft Landing"?
- Despite 525 bps of Fed rate hikes since March 2022, the U.S. economy remains remarkably resilient, growing at an annualized rate of 2.4% in the second quarter of 2023. In addition, inflation has receded in recent months, although it remains above the Fed's target of 2%. These developments raise the probability that the Federal Reserve will be able to bring inflation back to its target rate of 2% on a sustainable basis without a meaningful decline in employment, a so-called "soft landing."
- But to pull off a soft landing, the Fed will need to engineer a few quarters of sub-trend growth. Employment costs are rising at a rate that is not consistent with 2% inflation. In order to bring inflation back to target, the Fed will need to create some slack in the labor market via sub-trend economic growth, thereby leading to wage moderation and less upward pressure on consumer prices.
- We believe that the FOMC's tightening has come to an end. That said, we do not look for policy easing anytime soon, which will cause the real fed funds rate to move higher in coming months as inflation recedes further. In other words, there will be a passive tightening of policy. Our forecast implies that the real fed funds rate will rise to roughly 2% by the end of the year and that it will drift even higher in early 2024.
- The real fed funds rate has exceeded 2% in prior cycles without the economy slipping into recession. However, the potential rate of economic growth (i.e., the rate at which the economy can expand on a sustainable basis) was higher in those prior cycles than it is today. In other words, the U.S. economy was better able to handle a higher setting of real policy rates in those earlier cycles than it can today.
- We still think it is more likely than not that the economy experiences a few quarters of negative GDP growth and declining employment early next year. But we readily acknowledge that the probability of a “soft landing” has increased.
- A more rapid pace of disinflation than we currently project and/or a shift in the FOMC's tolerance of inflation could lead us to remove recession from our forecast. We will be watching developments closely in the coming weeks and months to determine if any major adjustments to our outlook are warranted.
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