In the past month, something that once seemed impossible suddenly became likely. After four years of upheaval, the U.S. now seems to have low inflation, low unemployment, and solid economic growth.
The popular term for this is soft landing. A better word is "normal." This is what an economy is supposed to look like.
Until Wednesday, one thing still looked abnormal: the Federal Reserve's interest-rate target, which at 5.25% to 5.5%, was much higher than economic conditions called for.
The Fed has begun to rectify that abnormality with its half-point rate cut. This vastly improves the odds of a soft landing. It might even leave the economy and interest rates looking more normal a year from now than before the pandemic.
To be clear, "normal" doesn't mean idyllic. Some people will be unemployed. Some people's wages will not keep up with inflation. Prices will rise gradually but won't go back to where they were before the pandemic. Normal simply means sustainable, without the excesses that lead to either recession or accelerating inflation.
A little over a year ago core inflation (which excludes food and energy) was around 4%, double its 2% target. That's using the Fed's preferred gauge, the price index of personal-consumption expenditures (PCE). With unemployment near a 50-year low of 3.5% and 1.5 vacancies for every unemployed worker, the Fed feared it would stay there.
And so it raised interest rates to a 20-year high, in essence declaring it would rather cause a recession than see inflation stay high. Markets adjusted accordingly: long-term bond yields, which reflect expectations of future interest rates, inflation and growth, stayed below the Fed's short-term rate target. Such an " inverted yield curve" has been a reliable predictor of recession.
The recession didn't happen because the abnormalities that drove inflation so high in the first place began to unwind. Supply chains straightened out and businesses responded to high prices by boosting capacity. Workers returned to the labor force (joined by new migrants), firms got staffing back to normal levels, and turnover dropped. Federal stimulus expired and mortgage rates rose.
With supply up and demand moderating, companies could no longer raise prices at will and workers couldn't get a raise just by changing jobs. In August, core inflation had fallen to an estimated 2.7%. Even that overstates the underlying trend because moderating rents have yet to fully pass through to official measures of housing inflation.
In projections released Wednesday, Fed officials see core inflation falling to 2.2% next year. Though above their 2% target, that's preferable to the sub-2% inflation that prevailed before the pandemic. That left too little cushion against deflation and the need for zero interest rates.
In the meantime, the unemployment rate has risen from 3.5% to 4.2% (the Fed expects it to edge up next year), and private-sector job growth has fallen to just under 100,000 a month, half the pace of a year earlier. This is not, though, because falling demand has led to layoffs, which so far remain low. Instead, firms have applied the brakes to hiring.
In fact, job growth and unemployment are close to what the Congressional Budget Office estimates ought to prevail in an economy at full employment and growing at its long-run potential rate. Indeed, Powell was careful to note that the job market is "actually in solid condition. And our intention with our policy move today is to keep it there."
While the Fed has only a vague idea of what an interest rate in normal times (dubbed "neutral") should be, it's sure the number is far below 5.25%. By cutting by half a point Wednesday, the Fed implicitly admitted rates have a way to go, and it was a bit late getting started. "We don't think we're behind. But I think you can take this as a sign of our commitment not to get behind," Powell said.
A return to the prepandemic era, when the Fed's interest-rate target was usually around zero and never above 2.5%, isn't in the cards. Those rates were anomalously low, reflecting a world of persistent deflationary pressure, subdued investment, and risk aversion.
The outlook today is for more upward pressure on inflation amid reversing globalization, shrinking labor forces, and the costly transition to net zero carbon emissions. Structurally larger government deficits will add upward pressure to interest rates. Looking out a decade, markets think a neutral interest rate will be 3.25% to 3.5%.
Yet as of Wednesday, 10-year yields were only a little higher, at 3.7%. In part, that reflected some investors betting that a recession would force the Fed to cut interest rates steeply again, if not quite to zero.
As confidence grows that the Fed has stuck the soft landing, long-term rates might rise, until they are above the Fed's rate target. Indeed, bond yields ended Wednesday slightly higher.
A world of higher bond yields will be a bitter pill for investors whose stockholdings have been buoyed by cheap money, or home buyers wondering why they can't have the 3% to 4% mortgage rates of a decade ago. And yet this would be one more sign that the world has truly returned to normal.
Comments