With the soft-landing scenario moving back into the spotlight, we will review where the key soft-landing indicators are at today and consider the direction of each as we move through 2023. To frame that up, a soft-landing looks something like this –
- Inflation slows and moderates around 2% target rate
- Growth stabilizes without entering a recession
- Unemployment rate stays around 3-4%
There are a couple of reasons why we track inflation and its components –
- They are a measure of consumer/producer demand (can consumers/producers bear the increased costs and continue to buy/invest in more goods/services in terms of volume) which has implications for broader economic activity.
- We are focused on the rates of change in the more cyclical, private sector demand components like goods and services excluding shelter prices.
- The Federal Reserve uses inflation as an input to its monetary policy decisions which can impact front-end rates.
- They tend to focus more on growth rates relative to their target rate.
With the Fed’s 2% target in mind, we can apply a range of m/m percent changes to the index. If the m/m growth rate increases 0.2%, roughly equal to the average pace over the last three months, the y/y growth rate will not move below the target rate by this time next year. At 0.1% m/m increases, the y/y growth rate would move below the target rate by January 2024. To get to 2% by the next FOMC meeting, the m/m pace would have to come in near -0.3% in August and September. An environment where the m/m pace comes in negative consecutively for several months would likely indicate a deceleration in demand and probably have negative implications for economic activity.
Looking at the current m/m setup, we have seen another step lower in the average m/m growth rate through the first half of 2023. The first seven months of 2023 have averaged 0.25% m/m, down compared to 0.52% m/m in 2022 and 0.58% m/m in 2021. In the last three month stretch, the average pace has slowed to 0.21% m/m. In terms of a soft-landing, this has been a positive development, but as demonstrated above, 0.2% m/m does not get CPI back to the Fed’s target rate.
Away from the scope of the Fed’s 2% target, it is worth reiterating the large and lagged contribution that Housing has on the headline index. When cycles turn, a +2.65-percentage point contribution from a housing environment that took place twelve to eighteen months ago probably does not provide a good indication of real-time consumer demand. Other inflation measures that are more oriented to private sector demand, like Goods PCE and Core Producer Prices, have decelerated at a faster pace than headline CPI, likely reflecting a slowdown in economic activity.
To simplify the inflation aspect of this possible soft-landing, a deceleration to the CPI target rate by year-end would likely be the result of a deceleration in demand, negatively impacting growth measures and an acceleration in inflation could result in a more hawkish Fed, which also likely contributes negatively to growth measures.
With that inflation setup in mind, we can review the growth side of the equation. For 2Q23, real GDP growth accelerated to an annualized q/q rate of 2.1%, revised down from the initial estimate of 2.4%. The two notable differences between the initial release and the second estimate were the contributions from GPDI, which was revised lower to +0.57 percentage points from +0.97, and government spending, which was revised higher to +0.58 percentage points from +0.45. In terms of real economic activity, we tend to focus more on private sector growth, which has mostly been slowing y/y on a rate of change basis despite the positive contribution to GDP. If that trend continues in 3Q23, alongside a deceleration in personal consumption expenditures, the largest contributor to GDP would likely be government spending. If GDP comes in at, or above, 2% for 3Q23 and the primary driver is the government component, we believe that is not a reflection of a healthy economic environment indicative of a soft-landing scenario.
On the private sector side, the slowdown in activity is already visible in the latest corporate profits data. For 2Q23, corporate profits after-tax without inventory valuation and capital consumption adjustments decelerated to -9.5% y/y, its third consecutive negative print.
A slowdown in private sector profitability can lead to hiring freezes and eventually layoffs. However, labor data has historically been a lagging indicator. Moreover, labor data like Nonfarm Payrolls can be volatile month-to-month and is highly revised. In fact, the net job revisions in the first eight months of the year have totaled -355,000. While the seemingly robust headline payroll numbers have garnered media attention at the time of release, the trend in jobs added has continued to weaken on a y/y basis. If the soft-landing were to occur, this data would have to stop decelerating. If this data continues to decelerate, then we would expect to see a continuation of the downward trend in consumer demand and a soft-landing becomes less likely.
Moving to the last point on labor, the Fed tends to focus on the unemployment rate. For the month of August this measure increased to 3.8 from 3.5 in the prior month. Part of this was driven by an increase in the participation rate. Over the next couple of months, the unemployment rate should level off or come down if those new entrants to the labor market can get jobs. If participation levels off again and unemployment continues to increase from here, then it could be a sign that the labor market is not as strong as some of the headline data has been suggesting. It is also worth noting that reaching low levels in the unemployment rate is not uncommon toward the end of an economic cycle. Therefore, it is important to consider the broader economic setup and the leading indicators that tend to decelerate before we see a material negative change in the unemployment rate.
To finish laying out the soft-landing scenario, we will look at a few market-based indicators. First, the U.S. Treasury yield curve has been inverted for several months. Looking at two of the most quoted curves, the 3m10y and 2y10y, we see that the depth of inversion is in line with prior recessionary environments. Second, the SOFR curve has been inverted between the December 2023 and March 2024 contract for several months. Additionally, the pace of decline as the contracts move out to the June 2024 and December 2024 contracts accelerates, indicating an increased probability of some negative economic environment that would result in lower yields. We monitor these curves because inversions have historically been a good leading indicator that the probability of some version of an economic slowdown has increased. The important takeaway from these curves is not necessarily the level of rates, but that the shape of the curve has mostly remained the same for several months in a row.
With inflation at 3.3%, GDP at 2.1%, and the unemployment rate at 3.8%, discussion around a soft-landing has been picking back up. However, for a soft-landing to occur, CPI still needs to fall about 130 basis points, GDP needs maintain the growth rate seen in 2Q23, and the unemployment rate needs to stay below 4%. As that discussion grows louder, interest rate curves have continued to signal a likely slowdown in economic activity.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Economic Analyst
Boyd Watterson Asset Management, LLC