The $64,000 question now is whether the Federal Reserve can quell raging inflation without pushing the economy into a recession. In other words, can the Fed engineer a soft landing?
Risks abound. Already GDP shrank 1.6% in the third quarter, following a 0.6% contraction in the second quarter. And the Fed is expected to raise interest rates by 50 or 75 basis points later this month. It has lifted rates by 225 basis points just since March.
Goldman Sachs Chief Economist Jan Hatzius is cautiously optimistic for the economy. “Since the [Fed] started hiking the funds rate early this year, we have argued that the economy can achieve a soft landing, even though the path is narrow,” he wrote in a commentary.
“It requires sustained … output growth, a rebalancing of the labor market via sharply lower job openings and a moderate rise in unemployment.” It also requires a “large decline in inflation,” Hatzius said.
Odds of a Downturn
“While much can still go wrong and our probability that a (mild) recession will start in the next year remains about one in three, we see some encouraging signs that the economy is moving toward all three of these goals.”
The growth element has advanced furthest among those factors, Hatzius said. “The initial slowdown in early 2022 came in response to the biggest decline in real disposable personal income in postwar history,” he said.
That was driven by “reduced fiscal support and much higher food and energy prices,” Hatzius said. “This hit has largely run its course, as the fiscal tightening is now behind us, and the renewed decline in energy prices has started to support real income.”
On the negative side, “the drag from financial conditions is still building,” especially the surge in mortgage rates, Hatzius said. “We remain comfortable with our forecast that U.S. growth will remain well below trend over the next year.”
Labor Progress More Incipient
As for the labor market, “news has also been encouraging, although the adjustment is at a much earlier stage,” he said.
“On the supply side, the labor force participation rate showed an outsized 0.3 percentage point increase in August that unwound the declines of the prior few months. On the demand side, payroll growth is starting to slow and net job openings have moved lower in recent months.”
Hatzius believes a “normalization of labor demand can push job openings down substantially with only a modest increase in unemployment.”
On the inflation front, the annual rise of consumer prices hit 8.5% in July, down from 9.1% in June. “The recent news on inflation has been particularly encouraging,” he said.
“Sharply lower commodity prices, a stronger dollar, and large improvements in supply-chain disruptions all suggest that goods price inflation will continue to abate.” On the service side, inflation progress is likely to be slow, Hatzius said.
