The trouble with good news

Recent data on consumer spending and the labor market have been better than expected, which ought to mean that a soft landing is more likely. Although we have pared back our expected decline in consumer spending, we maintain our call that recession is a more likely outcome than a soft landing.

The trouble with good news these days is that each improvement in the labor market and consumer spending makes it more difficult for the Fed to get inflation under control. This implies tighter rather than more accommodative monetary policy.

Yet, tight policy is already having a negative effect in other parts of the economy as the second-largest bank failure in U.S. history earlier this month demonstrates.

After what we have characterized as a hawkish pause, we expect the Federal Reserve to keep rates higher-for-longer than market pricing currently anticipates. We think the Fed will hold off on cutting rates through year-end 2023 though we do expect monetary easing to get under way in earnest at the start of 2024.

Ongoing stress in the financial sector is not the only threat to the outlook that worsens amid tight policy. Even if the debt ceiling is resolved without further incident, higher rates also make federal budget deficits more expensive to finance, a dynamic that implies that this debt ceiling fight won’t be the last.

As recessions go, the one we envision in our forecast is a comparatively mild one with a peak-to-trough decline of 1.0%, which is smaller than the 2.2% median decline across the past nine economic cycles.

Dark clouds gathering despite sunny data

When it comes to the most important factors influencing the outlook for the economy these days, it is a crowded and not particularly cheerful field. Consider just the top three: the uncomfortable dichotomy between the FOMC and the market about where rates are headed, ongoing instability in the banking sector that culminated in another U.S. bank failure earlier this month and a looming deadline with the debt ceiling and little in the way of progress to avoid it.

Yet for all that, the Federal Reserve and other authorities have, for now at least, largely succeeded in preventing a repeat of the credit crisis of 2008, which has been the explicit premise of our forecast since March. Unlike those scary days 15 years ago, this time credit markets have avoided seizing and equities have not faced a broad selloff. On the contrary, access to credit may be less widely available but credit markets are still functioning, and equity markets are broadly higher since March lows.

The titanic challenge for the FOMC is to administer just enough policy tightening to slow the jobs market and increase the cost of capital enough to take the swagger out of consumer spending and thus tame inflation without causing further collateral damage in the banking sector. To that end, the FOMC raised its target range for the fed funds rate by 25 bps in May, capping off a campaign that has hiked rates 500 bps since March 2022, the fastest pace of monetary tightening since the early 1980s.

The FOMC says rates are apt to remain higher for longer; the market disagrees. Market pricing may reflect concern about these other factors: the health of banking system and/or fallout from a disorderly handling of the debt ceiling. Lower rates could help ameliorate both and could thus explain why the futures market looks for a year-end fed funds rate of 4.32% as of this writing rather than the 5.00% or higher expected by 17 of 18 FOMC members, according to the March dot plot (Figure 1).

In ordinary times, we recalibrate our forecast on a monthly basis, considering the various ways the latest high frequency data inform our view on prospects for the coming quarters. Today, some clarity on these multiple threats such as the instability in the banking sector or a political standoff over the debt ceiling are just as critical as the economic data.

For months, we have maintained the explicit premise that systemic threat to the banking system will be avoided and that (eventually) the debt ceiling situation would be resolved. Even if those outcomes should come to pass exactly as we have described, it does not mean it will be smooth sailing. Even before the tumult in the financial sector took hold in March, lending standards were already tightening. It is also a fact that of the four largest bank failures in U.S. history, three have occurred in 2023. Even in the absence of additional fallout in the banking sector, the hair-whitening experience of the past three months will make access to credit both less accessible and less affordable. Meanwhile, even if a default in U.S. sovereign debt is avoided, last-minute grandstanding and dangerous games of chicken among lawmakers could add stress to already anxious financial markets.

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