Will the US economy stick a soft landing?

Encouraging signs that inflation is subsiding have fuelled hopes in the markets that interest rates are close to peaking and that, in turn, the US economy will avoid a major contraction.

The personal consumption expenditures (PCE) price index — the measure that the Federal Reserve uses to track its inflation goal — gained 3% in June 2023 from a year ago. The core PCE price index, which strips out the volatile food and energy components, increased by 4.1% year-on-year.

Many investors are thus increasingly confident in the chances of a soft-landing scenario — in which higher interest rates help to moderate price pressures without causing a deep recession or a big jump in unemployment rates.

Last week, the Fed hiked rates again as it continues to tackle still-too-high inflation. Policymakers at the US central bank on 26 July increased benchmark interest rates by 25 basis points (bps), in a widely expected move that brings the target range for the federal funds rate to 5.25% – 5.5%. Going forward, the Fed will be watching incoming macroeconomic data in deciding whether interest rates are to go higher.

Given the resilience of the economy, the central bank’s staff no longer forecasts a US recession. Fed Chair Jerome Powell on 26 July also said that “we do have a shot” for inflation to return to target without high levels of job losses.

Will the Fed pull off a soft landing as it balances a growth pullback and cooling inflation? Have we seen the last of rate hikes for this cycle? Here’s what fund managers think.

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Tighter policy all around

BlackRock, 31 July 2023

“The Federal Reserve hiked rates and said more could come: It may be overestimating the economy’s strength, we think.“

“Last week’s US PCE (Personal Consumption Expenditures) inflation and wage data showed a move in the right direction. But we fear an inflation rollercoaster as service price pressures persist — and jobs data this week will be key to assessing the outlook. The Fed, like us, is not yet convinced that inflation is on track to reach its target. It thinks economic weakness is the only way to get there — and sees resilient GDP (gross domestic product) and consumer spending as signs the demand in the economy is still too strong.

“We think the Fed may be misreading the economy’s strength based on low unemployment: That shouldn’t be taken as the usual sign of a buoyant economy, but rather a result of structural worker shortages holding back growth potential. We think this perceived strength raises the risk that the Fed hikes more than markets expect and then cuts as it generates too much weakness — rather than just holding tight.”

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US soft landing hopes rise as Fed raises rates again

Schroders, 27 July 2023

“Although the Federal Reserve’s latest interest rate hike could be the last in this cycle, policy is likely to remain tight for some time to come.”

"The economy has slowed, but has proven more resilient than expected and we would note that the IMF (International Monetary Fund) has just upgraded its projections for the US and the world economy this year. However, the IMF’s forecasts for 2024 remain unchanged, which would mean two years of weak activity, and Powell noted that the Fed staff are still looking for a noticeable slowdown in the US.”

“Our view remains that this will be the last hike in this cycle but we may be looking at a longer period of tight policy before the Fed can signal a pivot. As we have said before, it is in the central bank’s interests to keep a hawkish tone and prevent markets from loosening financial conditions until its goal is in sight.”

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No holidays for central banks: Where we think there’s more to come

Fidelity International, 28 July 2023

“Although both the Fed and the ECB (European Central Bank) sought to keep all options open and gave no guidance for the future path for rates… the key takeaway from the July meetings was that the hiking cycles are approaching their end. We believe, however, given the strength of the US economy and stickiness in core inflation, the Fed has further to go (in contrast to market pricing which points to no more tightening)...”

“Given the continued resilience of the economy, which delivered a large upside surprise in its advance Q2 GDP (gross domestic product) release this week, and the tightness of the labour market, we believe the Fed has further to go to ensure inflation is slowing on a sustained basis towards target, and inflation expectations remain well-anchored. Despite renewed hopes for a soft landing, we still expect the US economy to move into recession in coming quarters, though the timing remains uncertain as the length of policy lags and economy's sensitivity to higher rates seem to differ significantly in this cycle relative to history.”

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Fed cycle enters data-dependence phase

PIMCO, 26 July 2023

“Too soon to declare victory: [The] improving inflation outlook doesn’t change our scepticism about achieving an economic ‘soft landing’ in which inflation sustainably returns to target without a concurrent rise in the unemployment rate (and subsequent recession). US nominal wage inflation remains elevated, and absent recession, this will likely push core inflation measures higher again in 2024 — a scenario Fed officials will be very focused on avoiding.”

“Recession still likely ahead: Our baseline scenario still projects that the US economy will enter a mild recession late this year or early next – enough to bring the unemployment rate up and help inflation fully return back to target. That expectation, plus cooling inflation in the second half of the year, implies that July could very well end up being the last hike in this cycle. However, if the economy (and the labour market) continues to prove resilient, inflation is likely to settle uncomfortably above target and necessitate more restrictive policy.”

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Read more:

• Endowus Q2 2023 Market Update and Outlook
• Recession or not, here's how to invest in uncertain times, in seven charts

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