Recession risks have fallen as Fed halts rate hikes, looks toward cuts

For nearly two years, forecasters have hoped the Federal Reserve’s aggressive interest rate hikes would slow the economy enough to bring down inflation without causing a recession.

This week, that rare feat, known as a soft landingappeared to shift from possibility to likely scenario. Although recession risks are still historically high, it’s a change from last year, when a soft landing seemed to be little more than a pipe dream.

Here are the encouraging developments that some economists highlighted.

Is the Fed cutting rates in 2024?

First, Fed Chair Jerome Powell unexpectedly said Wednesday the central bank is probably done raising interest rates now that inflation is coming down more swiftly, and Powell and his colleagues forecast three rate cuts next year, more than anticipated. That means the Fed is no longer focused solely on fighting inflation and will devote at least as much firepower to supporting economic growth.

Put another way, an economy that the Fed was feeding Ambien will likely be receiving several B-12 shots.

The news further stoked a strong market rally from the past six weeks, with the S&P 500 index rising another 1.6% since the Fed announcement. The rally itself, if it continues, is another reason recession odds are falling.

Meanwhile, fresh data show inflation is falling faster than economists projected.

And another report underscored that consumer spending – which makes up 70% of economic activity – continues to hold up despite still high inflation and interest rates.

What is the probability of a recession right now?

Barclays has been predicting a mild recession next year but Jonathan Millar, the research firm’s senior economist, is no longer worried about the threat.

“The economy continues to power forward, inflation has come down” and the Fed is poised to lower rates, Millar says. “At this point, there’s no reason to write down a recession” in the forecast.

After the Fed news, Gregory Daco, chief economist of EY-Parthenon, says he lowered his recession odds from 50% to about 40%.

A soft landing is far from certain. The Fed will need to continue to walk a tightrope to achieve it. And with the economy expected to slow significantly next year, some analysts are still predicting a mild recession.

The Fed expects the economy to grow a tepid 1.4% in 2024, down from 2.6% this year.

“We’re not completely out of the woods,” says Kathy Bostjancic, chief economist of Nationwide.

Still, here’s why the odds that the U.S. can avoid a slump climbed this week.

The Fed pivot

After raising its key interest from near zero to a range of 5.25% to 5.5% since early last year — the most aggressive such campaign in 40 years – the Fed now says it foresees lowering the rate by three-quarters of a point next year. That, of course, depends on how the economy and inflation evolve.

Raising rates increases the cost of mortgages, auto loans, credit card purchases and other types of borrowing. That dampens consumer and business demand and cools the economy in an effort to slow price increases.

Cutting rates has the opposite effect by making borrowing cheaper and spurring growth. It also juices the market by making stocks relatively more attractive than bonds. As a result, Americans’ 401(k) balances and other investments rise in value. Over time, people tend to feel wealthier and spend more, which also boosts the economy.

Often, the Fed cuts interest rates to dig the economy out of recession. Next year, the Fed will cut mostly to bring rates closer to normal now that inflation is getting closer to its 2% goal, Bostjancic says. Otherwise, inflation-adjusted rates would rise.

Yet the central bank also would be trimming rates to head off a potential recession as the economy slows, Bostjancic says.

Inflation is slowing

A report this week revealed that wholesale costs were flat in November. That data feeds directly into the Fed’s preferred measure of consumer prices, called the personal consumption expenditure index. Barclays estimates a report next week will show that PCE prices dipped in November while a core measure was unchanged.

So far, inflation has been easing mostly because furniture, appliances and other goods that consumers snapped up during the pandemic have dropped in price as supply-chain snarls have resolved. The cost of services such as car repairs, health care and auto insurance have increased sharply, partly because of rising wages tied to pandemic-related labor shortages.

The Fed has been particularly keen on lowering those service prices by raising rates to cool off the job market and slow pay increases.

The November PCE inflation data is likely to reveal those cost increases are now slowing more dramatically, Millar says. While interest rates may be having some effect, many workers sidelined by COVID have returned to the labor market and immigration has rebounded, easing worker shortages and moderating wage growth.

Overall inflation likely fell to 2.7% from 3% in October and a 40-year high of 7% last year, Barclays estimates.

Consumer spending is resilient

Consumption has been surprisingly buoyant despite high inflation and rates as a result of healthy pay increases that recently began outpacing inflation.

In October, retail sales slowed sharply, raising concerns that household spending was finally losing steam. But retail sales increased by more than expected last month, highlighting strong holiday store traffic, according to a report this week.

The data showed that “the continued rapid decline in inflation is not coming at the cost of significantly weaker economic growth,” economist Andrew Hunter of Capital Economics wrote in a note to clients.

The labor market is sturdy

Job growth is slowing but remains solid, Millar says, with monthly gains averaging about 200,000 in the past three months. That’s down from 300,000 early this year but historically sturdy. And the 3.7% unemployment rate is modestly above a half-century low.

But here’s why some economists say a mild recession is still likely:

Signs the job market is sputtering

Although overall job growth is still sturdy, there are hints a steeper slowdown is coming, Bostjancic says. For example, service industries such as retail and restaurants that respond to the ups and downs of consumer demand gained only 22,000 jobs last month, she says.

Delayed effects of high interest rates, inflation

Although rates and inflation are expected to fall next year, they’re still high and consumers and businesses may start to feel their effects more intensely next year, Bostjancic says.

So far, many shoppers have coped with the higher costs by running total U.S. credit card debt to a record high. But, Bostjancic notes, delinquencies are rising and Americans won’t be able to continue to rely so heavily on credit to offset their rising costs.

COVID savings dwindling

The more than $2 trillion that Americans socked away from federal stimulus checks and hunkering down during the pandemic is running low, removing a buffer for high rates and inflation. For low- and moderate-income households, the cash reserves are virtually gone, says Ian Shepherdson, chief economist of Pantheon Macroeconomics.

Corporate profits are getting squeezed

Corporate profit margins already are narrowing as companies enjoy less pricing power amid lower inflation, Bostjancic says. Earnings are expected to come under more pressure next year as the economy downshifts, crimping sales, she says.

As companies struggle to maintain profits, they’ll probably step up layoffs, Bostjancic says. Job cuts have been limited because employers were reluctant to shed workers following pandemic-related labor shortages, but that could change.

New hit to grocery bills?Eggflation isn’t over yet: Why experts say egg prices will be going up

Fed must strike a delicate balance

If the Fed cuts rates too sharply, it could bolster the economy so much that inflation flares again, forcing the central bank to reverse course and hold interest rates steady or possibly even lift them again. That could again increase the chances of recession.

“I think that’s a real risk,” Barclays’ Millar says.