I’ve been too pessimistic about the risks of a so-called hard landing for the US economy over the past few years. Although most of my conclusions that led to that view were correct, such an outcome remains very much in doubt.
My reasoning went like this:
- How the Federal Reserve implemented its new average inflation targeting framework would cause it to be much too late in tightening monetary policy. Recall that the Fed committed to not raising zero short-term rates until the inflation rate was above 2%, was expected to stay there for a time, and the economy had reached maximum sustainable employment.
- But with monetary policy too loose, the labor market would become too tight and the economy would overheat.
- The Fed would then have to tighten a lot in order to make monetary policy restrictive.
- The unemployment rate would then rise at least 0.5%, triggering the Sahm rule denoting a recession has started.
Most of the story played out as I expected. But it’s fair to say that although the Sahm rule has been triggered, a recession remains very much in doubt. So although the risk of recession is higher than normal, there is a good chance that the Fed will get inflation back under control without causing an economic downturn.
First, the economy retains considerable forward momentum. Growth in the second quarter was revised up to a 3.0% annualized rate and the Federal Reserve Bank of Atlanta’s GDPNow estimate for the third quarter is currently 2.5%.
Second, the deterioration in the labor market has occurred in a way that is relatively benign. Although the unemployment rate has risen to 4.2% from a low of 3.4% in 2023, the increase has mainly been driven by rapid growth in the labor force rather than permanent job layoffs.
Third, the Sahm rule may not be as ironclad as historical experience suggests. Most important is to recognize that the 0.5 percentage point threshold was determined empirically from the US experience since 1960. That’s not a large number of business cycle observations. As Fed Chair Jerome Powell noted in a recent press conference, the Sahm rule is a “statistical regularity,” not an economic law. Maybe the actual threshold is higher this time because of how fast the labor force has grown. In that case, if the Fed eases fast enough to avoid a breach, the self-reinforcing dynamics that lead to a recession will be averted.
Fourth, although monetary policy remains tight by almost anyone’s standard, financial conditions have eased massively over the past year. Stock prices have soared to record highs, bond yields have fallen, and credit spreads have tightened.
What does this mean for financial asset prices? As I see it, a soft-landing scenario implies a buoyant stock market. Corporate earnings continue to grow and valuations relative to fixed-income assets are stable or improving.
In contrast, a soft landing implies somewhat higher bond yields for three reasons. First, if a soft landing were to occur, this would reinforce the notion that a federal funds rate consistent with a neutral monetary policy is considerably higher than in recent years. As I wrote more than a year ago, fair value for the 10-year Treasury note yield is probably around 4.5%. This assumes that inflation averages 2.5% over time, r* -- the neutral inflation-adjusted short-term rate — is 1%, and the term premium — the difference between expected short-term rates and the 10-year Treasury note yield — is 1%.
Second, with a soft landing, the Fed would presumably move policy to neutral, not accommodative. Judging from the futures market, traders anticipate the federal funds rate will bottom out around 2.9% in early 2026. In a soft-landing scenario, I’d expect the rate to bottom out no lower than 3.5%, compared with the current 5%.
Third, in a hard landing scenario, the outlook for stocks versus bonds reverses. Stock prices fall as earnings disappoint, and bond yields fall as the Fed cuts short-term rates more than expected so that monetary policy is accommodative. In this scenario, the federal funds rate probably bottoms out around 2 to 2.5%.
Which scenario will play out and how will we be able to tell? The key is the labor market. If it deteriorates further, and the unemployment rate keeps rising, the self-reinforcing dynamics that the Sahm rule embodies will take hold and we will have a hard landing. Looking back, we’ll either conclude that the 0.5% threshold still works or, alternatively, that it works once it goes through a threshold that is somewhat higher. Of course, we won’t be able to distinguish between these two cases.
In his press conference on Sept. 18 after the Fed lowered the federal funds rate by half a percentage point, Powell downplayed the risk of such an outcome. He argued that not only were the Fed’s dual mandate objectives in balance, but the downside risks to employment were no greater than the upside risks to inflation.
This benign view does not appear to be shared by most members of the rate-setting Federal Open Market Committees. In September’s Summary of Economic Projections, FOMC participants sharply altered their risk assessments from June. As can be seen in the two charts below, the upside risks to inflation fell sharply, and the downside risks to the labor market increased markedly. So much so that the downside risks to the labor market now dominate.
Fed officials are focused on the right portion of their dual mandate: the labor market. How the labor market unfolds will determine either a soft or hard landing.
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