Despite job gains, the Fed's 'soft-landing' narrative is looking suspect

Published Sun, Apr 3 20229:28 AM EDTUpdated Sun, Apr 3 202211:57 AM EDT

Maybe Friday's jobs report showed the economy has room to expand. Maybe inflation won't kill what has been a resilient consumer. Maybe the Ukraine war won't disrupt global supply chains enough to stymie growth. And maybe a flurry of interest rate hikes won't trump everything else and drag the U.S. into recession. All of those "maybes" are now confronting the Federal Reserve and making the central bank's challenge not to ruin the economic expansion all the more difficult. Officials including Fed Chairman Jerome Powell and President Joe Biden are confident that the Fed can raise rates dramatically this year without killing the recovery in place since the pandemic recession ended in April 2020. In a March 21 speech , Powell said he expects the Fed's rate hikes, done to combat inflation, will culminate in "a soft landing, with inflation coming down and unemployment holding steady." That will happen in large part, he said, because "the economy is very strong and is well positioned to handle tighter monetary policy." Biden, taking a victory lap Friday after a mostly solid nonfarm payrolls report , proclaimed that "Americans are back to work." "More and more Americans get jobs. As they do it's going to ease the supply chain pressures that we've seen," the president added. "That's good news for fighting inflation, that's good news for our economy, and it means that our economy has gone from being on the mend to being on the move." How fast that move will go, though, is up for debate. Wall Street economists increasingly are doubting that the Fed can reverse the loosest monetary policy in history without breaking anything. The battle against inflation After all, both the economy and the markets have been leaning on the Fed for more than two years now, with low interest rates and monthly bond purchases that have taken the central bank balance sheet to $9 trillion. "Our history of bringing about a soft landing with high inflation is very, very brief. It doesn't given reason for a lot of optimism," said Steve Friedman, senior macroeconomist in global fixed income at MacKay Shields. "When inflation is higher, the Fed has much less flexibility to react to downside growth risks. At the end of the day, they'll have to focus on price stability." Markets currently are pricing in rate hikes at each of the remaining six Fed meetings year , with expectations that a few 50 basis point increases will bring the year's total to about 250 basis points. They then see a couple more increases through the end of 2023 to bring the funds rate to 3%. After that, though, futures pricing points to two rate cuts in 2024 that would bring the long-run, or terminal, rate to 2.5%. In between, things could get sketchy. An inverted yield curve between the 2-year and 10-year Treasury notes points to fears of a recession in 2023 or beyond. Economists such as those at Goldman Sachs say the downturn probably will be "mild ," but it nonetheless poses a dilemma to the newfound inflation-fighting stance at the Fed. Thus, the question again of whether policymakers can pull it off. "The short answer to that is no, I'm not as confident," said Simona Mocuta, chief economist at State Street Global Advisors. "I'm watching not so much the current inflation trends and the unemployment rate. I'm watching the things that would make the Fed truly wary of a wage-price spiral." 'Crashes happen' Indeed, the 431,000 jobs added in March and the unemployment rate falling to a pandemic-era low 3.6% point to stability in the labor market, which, two years later, has recouped nearly all the Covid-related losses. However, wage increases accelerated, rising to 5.6% on a 12-month basis. That would have been a record in pre-Covid days, and it's a sign that inflation likely hasn't run its course yet. While inflation is raging at 40-year highs , growth is slowing. The Atlanta Fed is tracking first-quarter GDP growth of just 1.3%, coming after consecutive quarters of inventory-fueled gains that are running dry. That means it might not take much — say, a half-dozen rate hikes and an aggressive balance sheet rundown from the Fed — to knock the economy off its pins. A recessionary hard-landing "is not the baseline at the moment, but it certainly could become the baseline," Mocuta said. "If growth is slower quarter by quarter, it doesn't take a lot to push that into negative territory and you have a shallow technical recession." If the 2-year/10-year curve is to be believed, the bond market is pricing in just such a recession. The curve is not a recession "cause" per se, but can signal that the economy is susceptible to any unexpected jolts that might come along. "The Fed will continue to try – and talk about – engineering a soft landing, just as any good airplane pilot will tell you they are going to safely land the plane that they are flying," said Chris Zaccarelli, chief investment officer at Independent Investor Alliance. "But unfortunately crashes happen and we need to prepare for the likelihood that either inflation will continue to run too far ahead of a comfortable level or that the odds of recession are much higher and climbing." JPMorgan Chase economist Michael Feroli this week added that while Fed officials, who focus more on the relationship between the 3-month bill and the 10-year note as a recession signal, say bonds are not pricing in a recession, "they will likely be singing a different tune by the end of the year." "Both our models and the yield curve are comfortable with the growth outlook this year," Feroli wrote in a note for clients. "For growth prospects after the middle of next year, however, both sets of indicators start flashing yellow. The liftoff is not in question, but a 'soft-ish' landing in '23 looks iffy."

The Federal Reserve building in Washington, January 26, 2022.

Joshua Roberts | Reuters

And maybe a flurry of interest rate hikes won't trump everything else and drag the U.S. into recession.

All of those "maybes" are now confronting the Federal Reserve and making the central bank's challenge not to ruin the economic expansion all the more difficult.