From our perspective, U.S. Federal Reserve (Fed) Chairman Jerome Powell could not have put it better: "The time has come for [monetary] policy to adjust."^[1] But we would like to expand on that: The time has come for the Fed to begin engineering a soft landing. As we understand it, a soft landing is a situation in which an economy returns to growth close to its potential after restrictive monetary policy (in response to inflationary pressures) has reduced excess demand (growth rates above potential) without causing a recession. In the United States, the primary authority for declaring a recession is the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER). The committee's stated philosophy is to declare a recession when there is a significant decline in economic activity, focusing mainly on three criteria: depth, diffusion and duration.^[2] From our perspective, this is remarkably reminiscent of the Federal Reserve's oft-repeated "totality of the data" mantra. And since success in engineering a soft landing depends on when a recession is declared or not, it seems prudent to first spend some time understanding the NBER's thinking^[3] before turning to where we are right now and how the Fed is likely to act going forward.

Because the NBER's "depth, breadth, and duration" criteria for a recession are far more complex than the simple textbook case of negative growth for two or more consecutive quarters, a look back at recent history may help to understand what a recession in the US actually looks like. While the NBER declared a recession in February 2020, when the sharp pandemic-related decline in economic activity was historically significant but short-lived, it refrained from doing so in the first half of 2022, when growth turned negative for two consecutive quarters. The most likely reason for not declaring a recession at that time was the volatile nature of the decline. Net exports in the first quarter of 2022 and inventory liquidation in the second quarter of 2022 were the main drivers, but there was no broad-based economic slowdown like the one triggered by the pandemic. These examples show that there are degrees of freedom in defining a recession, and therefore, by definition, in defining a soft landing.

Looking through the NBER lens at current economic activity, a few things stand out. Growth in the first quarter of 2024, at 1.4% quarter on quarter (q/q) annualized, was already below estimates of potential growth of about 2.0% q/q annualized.^[4] Even if we take a closer look at the stellar growth rate of 3% q/q annualized in the second quarter of 2024, it becomes clear that about 1.2 percentage point are indeed volatile components that are unlikely to support growth again in the near future. Adjusted for volatile components, therefore, growth in the second quarter also appears to have been below potential. Below-potential growth has implications as it suggests that inflationary pressures should have dissipated and that monetary policy can be adjusted to avoid a further unwanted cooling of the economy, thereby avoiding a recession. Furthermore, looking ahead to the second half of 2024, the 0.8 pp contribution from an increase in inventories in the second quarter could weigh on growth if inventories are once again liquidated. This again implies the risk of a quarterly contraction as in 2022, but again would most likely not trigger a formal declaration of a recession. But there is more to consider. Low-frequency quarterly growth figures are only one part of the NBER's methodology, as they also consider a selection of monthly indicators on the real economy (excluding price data in contrast to the Fed), as shown in Chart 1.^[5]

 

Chart 1: NBER monthly economic indicators used to determine the start and end of a recession

 ^{Sources: NBER, Haver Analytics, DWS Investment GmbH, as of September 2024}

 

A quick visual check shows that the indicators support the narrative of a cooling economy: all of them have started to trend below their long-term averages (represented by negative z-values). While most of them remain in positive territory in absolute terms -- especially consumption - the above chart serves as a flashing amber light for central bankers to not only act, but to act quickly to prevent the slowdown from accelerating into a true recession as defined by the NBER.

The markets were quick to jump on this conclusion, especially since the incoming jobs data was much weaker than expected. The state of the labor market is not only part of the Fed's dual mandate, but also an important gauge of the health of the economy. Back in July, the so-called Sahm recession rule signaled the onset of a recession when the 3-month moving average of the unemployment rate rose 0.5pp above its 12-month minimum. We are not entirely convinced of the predictive power of this indicator. Our research suggests that it only has significance when total hiring turns negative, which is not currently the case. However, it does point to an interesting line of thought in describing the dynamics of labor markets that seems worth exploring further: Once the unemployment rate starts to rise, it seems to have a tendency to converge on a self-reinforcing path that makes it difficult to stop. This seems to be particularly true when labor demand is cooling at the same time, as it is now. One way to track this interplay between supply and demand is to compare the current unemployment rate with its efficient rate. This measure, unlike other equilibrium measures such as the non-accelerating inflation rate of unemployment (NAIRU), considers actual labor demand to determine whether there is slack or tightness in labor markets (see Chart 2).^[5]

 

Chart 2: Measure of tightness (slack) in U.S. labor markets: the efficient rate

^{Source: Haver Analytics, Michaillat, P. and Saez, E., DWS Investment GmbH, as of September 2024}

 

The results are quite striking. Not only is the tightness in the labor market (negative readings in the chart) disappearing quickly, but it has been doing so for quite some time. Moreover, unlike in past cycles, the labor market has been in a state of substantial excess demand, which has likely prevented the unemployment rate from rising more rapidly as it has in the past. Anecdotal evidence suggests that firms have been, and to some extent still are, hoarding labor. The experience of the post-pandemic shutdown period, when workers were hard to get, is still present, and firms preferred to keep people on the payroll rather than risk having to rehire them at a higher cost in the event of a renewed economic upswing. And there have been plenty of reasons to believe this in the past. Generous fiscal support, wealth effects from risky assets, and demographic effects that allowed people to retire and focus on consumption have all been factors that have kept the cycle robust and alive so far. But, as we know from the data, times seem to be changing. The depletion of excess savings, rising credit card delinquency rates, especially among lower-income and younger households, and slowing global demand may raise questions about how long the economic expansion can continue. This, in turn, could cause cost-sensitive companies to question the size of their workforces or, at least, reconsider their plans to expand them. The textbook line of thinking is that a resulting decline in demand for labor will reduce wage gains, which in turn could cast further doubt on consumer purchasing power and thus economic expansion. Already, income gains are lagging consumption, pushing the savings rate to multi-year lows and making labor income all the more important to consumption. With job openings now roughly equal to the unemployment rate, we believe labor markets are approaching this inflection point. Either the vicious circle will continue, with the unemployment rate likely to follow a self-reinforcing path, or the economy will receive some support in the form of less restrictive monetary policy. This could further support expectations of a soft landing among businesses and consumers, which in turn has the power to stop the vicious cycle just described. Anecdotal evidence suggests that heightened market expectations of rate cuts had a similar effect in the last quarter of 2023. At that time, markets mistakenly declared a sort of victory on inflation, only to be disappointed shortly thereafter as the disinflationary process stalled. Indeed, some might argue that excessive expectations of rate cuts were themselves the reason why inflation did not cool further. At the beginning of the year, markets priced in nearly six rate cuts by 2024, before reducing those bets to a little more than one cut around the spring. Now, with not only inflation likely to be back on track but also labor market conditions weakening, markets are turning dovish again, pricing in somewhere between 4 and 5 rate cuts for the rest of the year (Chart 3).

 

Chart 3: Expected rate cuts in 2024 as priced by markets

^{Source(s): Bloomberg, DWS Investment GmbH, as of September 2024}

 

With only three meetings left until 2024 at the time of writing, this implies even larger steps than the usual 25 basis points of cuts ahead. In recent decades, central bankers have typically only made cuts larger than the usual 25 basis points in times of stress, such as risks to the financial system. Since this is not the case at the moment, we should begin to wonder if there is some other motivation that leads markets to believe that central bankers will act in this way. At this year's Jackson Hole conference, Fed Chairman Jerome Powell said: "It seems unlikely that the labor market will be a source of elevated inflationary pressures anytime soon. We do not seek or welcome further cooling in labor market conditions." (1) In addition, he suggested that lessons had been learned from their complacent behavior during periods of rising inflation during the pandemic.^[6]This was widely interpreted to mean that larger-than-usual moves would henceforth be reserved not only for times of great stress, but also when warranted by economic data. Shortly thereafter, other Fed officials jumped on the bandwagon, providing the media with possible opinions on how to cut rates, ranging from "gradual" to "methodical" to "open to" larger than 25 basis points (bps) cuts as a likely response. ^[7] All in all, it appears that central bankers have indeed pivoted once again, but the degree and extent of monetary policy normalization remains a matter of debate. For us, a 50 basis point cut remains a rather severe measure. Perhaps the debate that central bankers are sparking is to manage expectations that there will be a quick response this time if the data gets even worse.

Since we already know that data on the real economy, especially the labor market, is softening, we should take the time to revisit inflation -- especially since there seems to be some complacency in the markets and perhaps among central bankers. Most recently, the August Consumer price index (CPI) report was a bit of a disappointment on the disinflation front. Core services prices spoiled the party as they were more robust than expected. However, the impact on the Fed's preferred measure, (core) Personal consumption expenditure (PCE) inflation, which adjusts weights to actual demand patterns, remains limited. Housing and transportation, the categories that disappointed, have lower weights in the PCE than in the CPI. Nevertheless, this latest CPI report, along with some pickup in wage pressures in August, is a reminder that inflation is still a relevant factor in setting monetary policy and that central bankers have not yet won the battle. This becomes even more apparent when we turn to the interplay between labor market tightness and inflation. We have written about this in the past (link). But given where we are right now, an update seems more than helpful in formulating expectations for what to expect next from the Fed. The relationship is not only the formal definition of the Fed's mandate, but it also illustrates the trade-off between slowing the economy and keeping inflation under control. This takes on added importance when the Fed's rationale appears to be shifting away from inflation and toward weakness in the labor market.

For this analysis, we use our measure of labor market tightness and compare it to the parts of inflation that are closest to wage developments: the so-called core PCE services inflation excluding the price of shelter. Volatile elements like food and energy prices can muddy the picture as central bankers try to smooth their response, and goods prices tend to be somewhat out of the Fed's control because they are tied to global factors like trade relations and global supply chains. The rest, shelter prices, remain very important, but their relatively rigid nature makes them candidates for isolated analysis. In short, the relationship with common indices of house prices and rents tends to be relatively stable with a 12-month lag, suggesting that short-term fluctuations are more noise than signal. That said, core PCE services prices excluding shelter, which account for about half of total PCE inflation, do indeed show a remarkable relationship with labor market tightness, as shown in Chart 4.

 

Chart 4: Stylized Philips-Curve indicating still indicating prices pressures from labor markets

 

 

Sources: U.S. Bureau of Economic Analysis, Haver Analytics, DWS Investment GmbH as of September 2024

 

Most strikingly, the relationship between labor market tightness and inflation appears to have evolved over time. Prior to the financial crisis (GFC) (2000-2008), inflationary pressures from tightening labor markets were higher and more responsive than in the post-GFC to pandemic period (2009-2019). This is illustrated by the different levels and slopes of the regression lines for the two periods. The excess demand for labor after the end of the pandemic seems to have exacerbated the relationship: as tightness built up (negative values on the horizontal axis), inflationary pressures followed disproportionately. The main question that arises as we track the evolution of the relationship since 2023 is where do we end up this time -- in a low inflation environment as in the post-GFC period, or in a slightly higher inflation environment as in the early 2000s? The post-GFC period was largely characterized by a prolonged economic recovery and ultra-loose monetary policy, which prevailed until the Fed was able to raise policy rates very gradually for the first time in 2015.

This time, however, the recovery from the crisis was very rapid and complete, and in the absence of another systematic shock such as a full-blown balance sheet recession, it seems that the pre-GFC period may be a better proxy for inflation and policy rates. Ultimately, time will tell, but a soft landing scenario is certainly not consistent with a post-GFC situation. This is one reason why we believe that inflation will approach the Fed's target from above 2%, rather than from below as was the case after the GFC. Such a scenario has important implications. Looking ahead, we will most likely have an "active" inflation-targeting Fed, which means that interest rates should remain high, probably slightly above neutral, and exhibit some volatility. Perhaps this has already been underway since 2015, when the post-GFC recovery was complete and only accelerated by the pandemic. Also, higher policy rates imply higher market rates, which, in the absence of any form of quantitative easing, could limit government borrowing by allowing bond vigilantes. Finally, looking further out, it could also mean that potential growth is actually being supported as the quality of investments, and hence earnings, improves as money once again bears opportunity costs.

For the Fed, however, the task remains of engineering such a soft landing in the first place. Chart 4 can serve as a runway map. All central bankers need to do is keep the economy on track toward the vertical zero line, which represents a labor market in equilibrium. If the economy begins to drift to the right (i.e., slack is building in labor markets), more cuts are likely to be needed; if it drifts to the left (labor markets are tightening again), fewer cuts may be appropriate. In doing so, central bankers should keep in mind that the response of inflation does not yet appear to be linear. And if this task is not delicate enough, many potential shocks remain in the way. High election-related uncertainty about future fiscal and economic policy, the threat of a government shutdown in the meantime, and a challenging global economic and geopolitical environment make the task even more difficult.

All told, we expect the Fed to cut rates three times by 25 basis points this year and perhaps three more times by the same amount by Q3 2025, the end our forecast horizon. This should bring the federal funds target range to 3.75-4.00, which we believe is still above neutral. Given the relationship between the labor market and inflation, further or larger cuts could indeed prove counterproductive again, as we still see some wage and inflationary pressures. If economic data continue to deteriorate, 50 basis points remains possible but is not our base case. While we remain optimistic about a soft landing, we see the glide path narrowing and believe that the risk of a genuine NBER-type recession in the next twelve months has risen significantly to just below 40%.

Overview: key economic indicators

	2024				2025
	Q1	Q2	Q3**	Q4**	Q1**	Q2F	Q3F**	Q4F**
GDP (% qoq, annualized)	1.4	3.0	1.2	1.0	1.6	2.0	2.4	2.4
Core inflation (% yoy)*	2.8	2.6	2.5	2.3	2.2	2.2	2.2	2.2
Headline inflation (% yoy)*	2.7	2.5	2.5	2.3	2.2	2.2	2.2	2.2
Unemployment rate (%)	3.8	3.9	4.3	4.3	4.2	4.1	4.0	4.1
Fiscal balance (% of GDP)				-6.0				-5.9
Federal funds rate (%)	5.25 - 5.5	5.25 - 5.5	5 - 5.25	4.5 - 4.75	4.25 - 4.5	4 - 4.25	3.75 - 4	3.75 - 4

*PCE Price Index

** Forecast

 

Source: DWS Investment GmbH as of 9/12/24

Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect.