When it comes to predicting the course of the US economy, the hardest thing to do is pick which battles to fight. For economists and forecasters, it's easy to get extreme — the deluge of data and pressure to be noticed lead a lot of people to declare that the sky is falling or that the boom times are just around the corner. For a central bank such as the Federal Reserve, which is tasked with the even more difficult job of maintaining the balance of the economy, landing on exactly the right amount of support or pressure can be a tough task.
The difficulty was on full display this year. Most economists started off the year worried that the US would fall into a recession at any moment. This prediction was based on dubious evidence, and as the American economy proved resilient over the course of the year, it turned out to be wildly wrong. For my part, I was always worried about the opposite: the possibility that the strong economy would reignite inflation, forcing the Fed to ramp back up its interest-rate hikes.
While public forecasters stumbled throughout the year, the Fed appeared to pull off the balancing act. Current economic data is consistent with a soft landing for the economy — a situation in which inflation cools without causing a recession or sudden spike in unemployment. And Fed Chair Jerome Powell is in a more forgiving mood: Based on recent comments, it's highly unlikely that interest-rate hikes will be back on the menu anytime soon, even if the economy suddenly shows signs of heating back up.
All this is good news for American households, as the cost to borrow money — from credit cards to mortgages — will gradually decline alongside everyday expenses. It's also a favorable setup for financial markets. Stock prices have contracted for nearly two years as bond yields have surged. But with rates stabilizing, if not falling somewhat, stock returns are poised to boom. If 2023 was about the hard work of stabilizing the economy, then 2024 is about enjoying the fruits of that labor.
Coming in for a soft landing
The signs of a well-balanced economy are everywhere. The most obvious example is the slowdown in inflation. The core consumer price index, the widely cited measure of inflation that strips out volatile categories such as food and energy costs, has risen since June at an annualized rate of 2.8%, roughly half the pace heading into the year. And there are clear signs of continued disinflation on the horizon: Wholesale auction prices for vehicles imply used-car prices could start to come down, private measures of rent prices suggest that housing inflation will continue to cool off, and an improvement in supply chains suggests prices for core goods outside cars, including washing machines and clothes, will ease.
If 2023 was about the hard work of stabilizing the economy, then 2024 is about enjoying the fruits of that labor.
Another positive signal is coming from productivity data, which measures a worker's output within an hour. Productivity growth strengthened notably in the third quarter, hitting its highest nonrecession level since 2003, and appears to be growing in line with its pre-pandemic trend. The growth in the number of hours people are working has slowed, but output has been steady, meaning people are accomplishing more in less time. This boom in productivity means that as workers get more efficient, businesses can give employees pay raises without having to turn around and pass on those increased labor costs to consumers in the form of price hikes.
While things are slowing in the labor market, it's not enough to cause a panic about unemployment. The October jobs report — with the economy adding just 150,000 jobs and the unemployment rate ticking up to 3.9% — was a disappointment. Of particular notice, the unemployment rate has increased by half a percentage point over the past six months. The uptick in joblessness is close to triggering the Sahm rule, which states that the economy is in recession when the average rate of unemployment over the prior three months is half a percentage point above its prior 12-month low. The current three-month average is 3.8%, a meaningful uptick from the low point of 3.5% in April but not quite high enough to hit the 4% average needed to trigger the rule.
But the job market isn't all bad news. Over the past three months, average hourly earnings for all employees have jumped 3.2% — a strong number for American workers that's broadly consistent with the Fed's long-term inflation objectives. It's also highly likely that the last employment report understated the growth in nonfarm payrolls since tens of thousands of workers were on strike. (You need to be on the job to be counted as employed.)
For now, I view what we are seeing in the labor market as a normalization, not a harbinger of increasingly worse news on the jobs market. A simple way to show that things are still in balance is to look at Okun's law, a relationship between movements in the unemployment rate and economic activity. With changes in the gross domestic output as the measure of economic activity, the unemployment rate has been running below the Okun implied rate, suggesting that the recent uptick in the unemployment rate is about where one would expect given the growth in the economy, not too hot or too cold.
Don't rock the boat
The difficulty heading in 2024 is maintaining this even-keeled economy. Just because things look good now doesn't mean they're guaranteed to stay that way.
The biggest risk to our stability is that the softening of the job market could turn into a serious downturn. The trouble with unemployment is that it's nonlinear. The jobless rate never goes up just a little bit. The historical record shows that once it rises half a percentage point, the unemployment rate tends to rise even more. The unemployment rate is already above the Fed's year-end forecast of 3.8% — the first time that's happened since March 2022. If it looked like the jobless rate might surpass the Fed's year-end 2024 prediction of 4.1%, that would open the door to interest-rate cuts relatively quickly. The Fed does not believe things have fundamentally changed about what constitutes a neutral economy, so any further deterioration in the labor market would be a signal that it overtightened and needed to reverse course.
In an environment with a moderating labor market and easing inflation, the Fed has a strong case to do surgical interest-rate cuts — a modest recalibration of policy to keep the outlook steady. The momentum under the economy and loosening of financial conditions we have seen may limit the number of cuts we get, but the Fed can at least justify a modest change in its policy stance. After all, a quick look at the Fed's previous rate-cut record, shown in our nearby table, suggests the timing for the first reduction would be well within the historical norm.
There are, of course, risks in the other direction: If the Fed starts to cut rates, it could reignite activity to a degree that inflation once again rears its ugly head.
The most obvious sign that things could go in this direction comes from financial conditions — the signals given by investors that are implied through the movement of stock prices, bond yields, and mortgage rates. As of now, it appears that investors are expecting some easing from the Fed in 2024: Mortgage rates are dropping, stock prices have jumped, and corporate credit spreads have tightened. This is OK given the slowing in inflation we have seen. But a more rapid acceleration in asset prices that leads to a pickup in inflation expectations might be a concern. Fortunately, we're not there yet.
What's changed for me
While there are risks that could disturb our economic equilibrium, the chances of a placid 2024 are becoming more real with every data release. Sure, the economy is likely to slow, but after a strong third quarter, some slowing was inevitable. It's important not to get carried away and to take a sober view of the larger picture. The economy is still growing above 2%, and that's likely enough to keep the unemployment rate from rising enough to crimp people's incomes.
Thinking through the scenarios for the year ahead, I will say what's changed for me is that the odds of surgical interest rate cuts by the Fed have increased (in my estimate, this possibility has moved from a 30% chance of happening to 50%), while the odds of additional hikes next year have decreased (50% to 30%). And the likelihood of a more aggressive easing cycle to combat a broader slowdown has remained unchanged (20%). Obviously, these are very subjective probabilities. But I'm not inclined to see an aggressive easing cycle because I think the risk of recession remains low: Real incomes are rising, household balance sheets are strong, other central banks around the globe have already started easing (likely supporting growth), and the government is running an expansive fiscal policy.
While there are risks that could disturb our economic equilibrium, the chances of a placid 2024 are becoming more real with every data release.
If I'm right, and the Fed is cutting rates even as the economy continues to grow at a modest pace, it will be a nirvanalike situation for equities. While stock prices are up already, many stocks have underperformed the broader market. If the Fed indeed cuts rates next year, it could provide a lift to some of these laggards.
At any rate, the economy and markets have been quite the whirlwind this year — from recession to no landing, from no landing to hard landing. You can liken the economy to a matrix between growth and inflation: deflationary bust, modest growth and benign inflation, inflationary boom, and stagflation. At the moment, it's clear that the odds of continued growth alongside slowing inflation are rising.
Neil Dutta is head of economics at Renaissance Macro Research.