Markets are increasingly confident that the US Federal Reserve will successfully engineer a soft landing for the US economy. The Fed’s interest rate hikes aim to bring down inflation without pushing the economy into recession or causing a sharp rise in unemployment. However, achieving this outcome has historically been challenging.
Fed chair Jerome Powell has warned that the path to a soft landing is narrow, especially considering the 500 basis points of rate hikes implemented so far. Despite this, the S&P 500 and Nasdaq stock market indices have risen by 16% and 25% respectively since spring, as more US data point towards a soft landing. This positive trend may soon allow the Fed to conclude its rate hiking campaign.
Encouragingly, the consumer price inflation data for June showed promising signs. The US headline inflation rate dropped to 3% from 4% in May and 4.9% in April, now well below the peak of 9.1% reached a year ago. Additionally, the core inflation rate, which excludes food and energy, declined to 4.8% from 5.3% in May and 5.5% in April, with a peak of 6.6% in September 2021.
Although the core inflation rate remains relatively high, it is expected to decrease further in the coming months. This will be driven by positive base effects as large increases from last year are excluded from the annual rate, as well as easing price rises during the summer. Despite a slowdown in growth, the US economy continues to perform well. Job creation momentum has weakened, but non-farm payrolls still average almost 250,000 in the past three months. The unemployment rate remains close to 50-year lows, standing at 3.6% in June. GDP grew by 2% annually in the first quarter, and data indicate another solid increase in the second quarter.
The economy’s resilience in the face of rising interest rates can be attributed to several factors. These include the high level of job vacancies following the pandemic, which has led to continued employment expansion, and strong household balance sheets with elevated savings. Additionally, the expansionary fiscal policy, along with increased wage growth and wider profit margins for firms, has supported economic activity.
However, it is important to note that the full impact of higher rates has yet to be felt in the real economy. The decline in inflation, despite solid economic growth and a tight labor market, has been referred to as “immaculate disinflation.” Much of the inflation rise in 2021-2022 was due to supply-side shocks stemming from COVID-19 and the conflict in Ukraine. Market expectations suggest that the deceleration in inflation will allow the Fed to pause its monetary policy after delivering one final, well-signaled 25 basis point rate hike at the end of this month.
Nevertheless, there is still a long way to go to bring core inflation back down to its 2% target, so it will be some time before rate cuts become a consideration for the Fed.
In conclusion, while the US economy shows signs of a soft landing, there are still challenges ahead. The Federal Reserve’s efforts to manage inflation and maintain economic stability will be closely watched. Only time will tell if their strategies prove successful in the long term.
Oliver Mangan is the chief economist at AIB.