A recession suddenly looks like it can be avoided
Higher interest rates are no doubt causing pain to investors and consumers, but the economy has been able to handle them better than anyone thought possible six months ago. The worst-case fear was that the Federal Reserve would move too aggressively to cor- rect inflation caused by pandemic distortions in the supply chain, wages and the housing market, and that as those kinks worked themselves out, rising rates would leave the economy crippled by soaring unemployment while inflation was still too high.
Last week’s steady jobs report should now put those fears to rest. The labor market has remained resilient enough to buy time for supply chains to heal and for many of the pandemic-related problems to ease. That’s providing a clearer path for the Fed to target inflation. Should the Fed feel the need to push the economy into recession in 2023, it will be due to an accurate read of structural inflation dynamics rather than data that’s been overly influenced by COVID shutdowns.
Investors began bracing for a recession in June, when the Fed began its series of 0.75% interest rate increases after the shock of May’s elevated Consumer Price Index report. Some saw the bigger hike as an overreaction. The theory was that the housing market was already buckling due to rising mortgage rates and the labor market would soon follow. Meanwhile it could take many months before the inflation data turned down, prompting the Fed to unnecessarily induce a recession because they got head-faked by an economy already in the process of normalizing.
It’s now been five months and those fears have not come to pass. The rate at which workers are quitting their jobs has fallen to the lowest level since early 2021 as the “Great Reshuffle” of workers winds down, and wage growth in pandemic-affected industries like leisure and hospitality has decelerated significantly since 2021 as businesses became better staffed. Yet the economy continues to add more jobs than expected each month. In fact, even as layoffs are accelerating, the labor market still remains too strong for the Federal Reserve’s liking.
Market pricing in June suggested investors were expecting the Fed rate would rise to 4% in March 2023. Markets are now priced for the Fed Funds rate to rise closer to 5%. Despite that, there’s now a view that the higher level would still be consistent with a soft landing in the economy, and stocks would probably rally if cooling inflation allowed the Fed to pause at 5%.
While inflation remains too hot, every month that passes there are signs that the factors influenced by the pandemic are normalizing. Used vehicle prices in the CPI data have been falling modestly since January, in part because automobile production is picking up after the industry has been snarled by supply chain issues. The cost to ship goods by container ship or truck has fallen. Homebuilders expect cost and supply chain relief in the new year as prices of key inputs such as lumber have fallen.
Most encouragingly, data in recent months indicate that rents for new apartment leases are coming down, as Fed Chair Jerome Powell discussed in his press conference last week. About the decline in new leases, he said, “What they’re telling you is there will come a point at which rent inflation will start to come down. So we’re well aware of that, of course, and we look at it.”
When people were worried about the Fed inducing an unnecessary recession in June, the thinking was that we just needed to buy time for the pandemic effects in the economy to wear off so that the Fed could at least have a clean read of the situation rather than overreact to temporary factors. We now know that the labor market has bought us that time, and the economy has remained more resilient than the doubters thought.