PIMCO’s Wilding: Assessing the Risk of a ‘No Landing’ Scenario in the US

by | Feb 7, 2024

In her latest update which we’ve shared in full below, Tiffany Wilding, Managing Director and Economist at PIMCO, offers analysis and research on economic themes that are likely to influence markets. She also stresses the need to stay mindful of the risks whichever direction the US economy takes.

Bottom line: We find recent [economic data] indicators, taken as a whole, are not as consistent with a soft landing as the optimistic market narrative seems to suggest. While we are still forecasting the Fed to begin cutting rates around midyear, recent data have underscored how progress on inflation in 2024 may be slower and more nuanced than in 2023. The soft landing narrative remains compelling, and indeed possible. But investors should stay mindful of the risks in either direction.

Many investors, having pushed the stock market to new highs and bond yields down by nearly a full percentage point in recent months, appear to be celebrating an unlikely achievement – a soft landing for the U.S. economy. However, historical precedent and the latest macroeconomic data leave us hesitant to call this a soft landing. The U.S. economy isn’t out of the woods yet.

Optimism has been fuelled by the U.S. economy’s resilient growth over the past year despite many challenges – high interest rates, dwindling fiscal support, stagnant global growth, and regional bank turmoil. What’s more, inflation has fallen considerably from its 2022 peak, prompting many central bankers to signal that cuts will likely be appropriate later this year.

We agree the chances have increased that central banks pull off what historically has been elusive: A soft landing remains possible. However, we’re monitoring risks in both directions: the potential for growth to stagnate, or for inflation to reignite. We also believe the Federal Reserve would likely respond swiftly and decisively to rising inflation. Central bankers don’t want to repeat the price spikes of all too recent memory.

The ingredients of a soft landing
In our Cyclical Outlook published in January, we summarized our analysis of central bank rate cycles since the 1960s. Across that historical span, soft landings tended to have three interlinked ingredients: 1) a positive supply shock (e.g., a productivity boom, international trade expansion, OPEC oil production acceleration) that 2) reduced inflation in a sustainable way to 3) allow the central bank to cut rates relatively quickly.

The current economic cycle shares some of these ingredients: There’s been a material post-pandemic recovery in global supply chains and labor supply, which has helped moderate inflation dramatically. This has led central banks to signal their next move will likely be a rate cut, increasing the chances of a soft landing.

However, a critical element – productivity – has stagnated across developed markets (DM), with the exception of the U.S., which has managed to get back to its pre-pandemic trend. Thus, with less room for post-pandemic gains from supply chain and labor force recoveries, the risks of inflation reaccelerating and recession still appeared elevated.

Sticky inflation risks look particularly pronounced in the U.S., where we believe growth could be more resilient than in other DM economies. U.S. growth benefits from the relatively slow pass-through of higher market rates into outstanding debt service payments, higher real excess consumer savings due to larger pandemic-related fiscal stimulus, and legislation aimed at supporting infrastructure, renewable energy, and supply chain investments. An easing of financial conditions could further support growth, and eventually stoke inflation.

Recent macro developments raise inflation concerns
The latest U.S. macro data, including Friday’s employment situation report, underscore the risks we’ve been flagging.

The January payroll report can be notoriously difficult to parse: Each year, the U.S. Bureau of Labor Statistics (BLS) revises the monthly figures using delayed but better-quality source data, complicating analysis of data trends (and this year, bad weather in January likely distorted both hours worked and average wage inflation).

However, on net, the revised payroll data suggest that labor market momentum is no longer decelerating. Instead, it may be flattening out at a still robust pace, or perhaps even inflecting somewhat higher. The three-month moving average monthly payroll gains are now reported at around 290,000, higher than the six-month average of 250,000. Both moving averages are well above the roughly 100,000 monthly average payroll gains that most economists agree are needed to keep the unemployment rate stable (given expected population growth and a stable labor force). Similarly, the ratio of job openings to unemployed workers has recently started to flatten out at 1.4, up from around 1.1 pre-pandemic. Certain sectors – healthcare, education, and government – still have elevated openings, and a tough time finding workers with requisite skills, according to the BLS.

Progress on wage inflation has also slowed recently; it remains above levels consistent with the Fed’s 2% inflation target. The January average hourly earnings figures were likely distorted higher by a notable decline in hours worked. However, similar to the payroll data, the yearly revisions materially changed the reported wage inflation: The year-over-year pace was revised up to 4.5% from 4.1% previously, effectively negating the downward momentum over the last six months.

Along with the establishment survey wage inflation metric, household survey data – which informs the Atlanta Fed wage tracker – also shows a flattening out in wage trends. Digging into the details, we find that the recent flattening out in aggregate wage inflation is being driven by college-educated professional and business services jobs. These were people who generally didn’t switch jobs to pick up higher wages during the pandemic, but now are successfully bargaining their current employers for higher wages. However, we also find the more flexible wages in the leisure and hospitality sector – where we saw the initial surge in wage inflation as pandemic restrictions eased – also appear to be flattening out above their pre-pandemic pace.

Wages are less flexible than prices and tend to lag, and with a tight labor market (although less tight than a year or two ago), some post-pandemic catch-up in real wages still appears likely. The nominal wage level thought to be consistent with the Fed’s target is 3% (2% target inflation + 1% trend productivity growth); in their latest readings, the Atlanta Fed wage tracker is at 5.6%, with average hourly earnings at 4.5%, and the employment cost index at 4.2%.

Labor markets aren’t the only data showing nascent signs of accelerating. A range of sentiment and purchasing managers surveys, which tend to be early indicators of GDP momentum, also appear to be rising. Indeed, the latest Fed senior loan officer survey suggests the percentage of banks tightening credit conditions has fallen substantially, while loan demand has rebounded (albeit from a low level).

The narrative amid the noise
What does all of this mean?

Although economic data can be noisy, we find recent indicators, taken as a whole, are not as consistent with a soft landing as the optimistic market narrative seems to suggest. While we are still forecasting the Fed to begin cutting rates around midyear, and to deliver around 75 basis points of cuts this year, recent data have underscored how progress on inflation in 2024 may be slower and more nuanced than in 2023. This gets even trickier if underlying U.S. growth momentum stays resilient (or even reaccelerates) this year.

We worry that with supply-side improvements having largely run their course, the recent good news on (dis)inflation may not last, and market expectations could quickly shift from a soft landing scenario to a “no landing” outlook. Although we don’t think recent data is (yet) enough to materially change the Fed’s projections for rate cuts this year, Fed officials did seem concerned enough about this risk to delay cutting the policy rate until after March (for details, see our blog post, “Fed Slowly Building the Confidence to Cut”).

If current macro trends don’t reverse in the coming months, a new question may emerge: If banking turmoil, tight monetary policy, and a weak global growth environment can’t rein in the hot-running U.S. economy, what can? We fear the answer may be materially tighter financial conditions, or a negative credit shock.

And to this last point on financial conditions, we also note that stress in the regional banking sector has resurfaced. While we don’t believe these issues are likely to become systemic, they do emphasize how high rates can create an environment of increased financial stability risks that also elevate the odds of recession. And the longer the Fed remains in restrictive territory, the greater the risk of financial market accidents.

The soft landing narrative remains

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