Factors Supporting a Soft Landing
The healthy job gains in the November Employment Report underline the resilient economy and are consistent with sustained expansion. While employment is a coincident indicator, it’s important to understand the key factors that support a soft landing, or at minimum would likely make any economic downturn sufficiently mild that it will not take on the characteristics of a typical recession.
*Consumption growth will slow, but it will be supported by continued increases in real disposable income, declines in real interest rates, and record high household net worth that lifts the propensity to spend. Consumption of services will continue to rise while spending on goods will fall.
*Residential investment, including spending on new construction and home improvements, which typically falls during recession, now looks firm following its decline in 2022, and moderating mortgage rates and ongoing shortages of homes for sale provide a positive outlook for 2024 and beyond.
*Business investment is being boosted by the government’s tax credits and other incentives. In addition, the growing importance of investment spending in software and R&D, which is now over 40% of total business fixed investment (BFI), significantly dampens the cyclicality of business investment, traditionally a major contributor to recessions.
*Government purchases (consumption and investment) have been contributing significantly to GDP growth, with rapid gains in spending on the infrastructure initiatives and higher defense spending. These government programs are generating government jobs and more employment in private construction, defense, and related sectors. Spending on infrastructure, government-subsidized investment, and defense spending will continue to rise rapidly in 2024.
Employment and consumer spending drive each other. Businesses continue to increase employment to meet rising product demand, which increases disposable income, the major source of demand. Unlike prior mature stages of economic expansions when businesses had excess labor relative to output, which made jobs vulnerable, pandemic labor shortages constrained business hiring. As a result, employment is well aligned with output. Some businesses facing weak demand are keeping labor and reducing hours because of the high costs and disruptions of job layoffs and rehiring. Moreover, in general, businesses have efficiently managed inventories and in situations in which undesired inventories have resulted from soft demand, like select retail sectors, high levels of business cash-on-hand provide businesses flexibility to cut product prices and absorb squeezed margins.
Meanwhile, the heightened business flexibility in using labor inputs and mobility of labor supply is reflected in the strong employment gains in the Household Survey (+747,000 in November and +2.2% yr/yr versus 1.8% in establishment payrolls). Paralleling this, there has been a sharp rise in new business applications (Chart 1). This is contributing to personal income gains. Moreover, the recent surge in new business applications and mobility of labor may be the precursor of sustained gains in productivity.
Chart 1.
The combination of job gains and wage increases — average hourly earnings are up 4% yr/yr — have boosted real (inflation-adjusted) disposable personal income, by far the most important factor driving consumer spending by 3.8% yr/yr. This is materially higher than the average annual increase of 2.4% during the 2010-2019 expansion or the 2.6% annual rise during the 2002-2007 expansion. Gains are expected to moderate. However, there are offsetting factors. As described below, an array of government spending initiatives are increasing government employment and also increasing jobs at private contractors, particularly in health and social services, construction and in defense related activities. In addition, the recent decline in interest rates and funding costs will support debt-financed consumption. Also, increases in household net worth to record-breaking highs increases the propensity to spend disposable income.
The interest sensitive sectors. Two of the most traditionally interest-sensitive sectors of the economy, motor vehicle sales and housing, have fared well in response to the Fed’s 5.5 percentage point increase in interest rates and the higher mortgage rates. Auto sales drifted lower when the Fed was hiking rates aggressively in 2022 but in 2023 have risen and remained above the 15 million annualized pace despite significantly higher borrowing costs. Over 80% of all new motor vehicle sales are financed. The gradual easing of inventories for sale has helped. The recent declines in financing costs and increased production following the UAW strikes will support sales in 2024. Housing activity—sales, construction and home improvements—have been characterized by offsetting factors:
- Favorable: rising employment and disposable income and low unemployment, demographics and new family formation; the heightened mobility of labor; and record-breaking household net worth
- Unfavorable: insufficient inventories of homes for sale, high prices (the Case-Shiller Home Price Index is up 45.5% from pre-pandemic levels), the moderately high mortgage rates, and the lowest affordability index in decades.
The recent decline in mortgage rates will provide some relief to homebuyers. Housing activity will have a strong 2024. While residential investment is only 3.3% of GDP (down from 4.4% in 2021Q1 and 6.8% in 2005Q4), it punches well above its weight in contributing to economic activity and jobs.
The changing composition of business investment. Business investment in software and R&D have become increasingly important components of BFI and critical to technological innovations and new product development.Investment spending in software and R&D investment is different than traditional business fixed investment in equipment and structures in three ways: 1) it tends to be financed with internal cash flows rather than debt or equity, 2) it is less interest rate sensitive and 3) it is less cyclically sensitive. Strikingly, business spending on software and R&D has risen to over 40% of total BFI and, strikingly, it barely declined during the severe financial crisis and deep recession of 2008-2009 recession and continued to rise rapidly during the 2020 pandemic (Chart 2). Businesses must maintain leading-edge software to remain competitive and R&D has become the mainstay for many growth firms. Thus, business investment can be expected to dampen any contraction.
Chart 2.
At the same time, the generous 25% tax credits and other provisions of the CHIPS Act are stimulating business investment in computer chip, battery and related manufacturing facilities. This is largely offsetting the depressing impact of the adjustments in commercial real estate on business investment in structures.
Fiscal stimulus. Combined, the American Infrastructure and Jobs Act, the CHIPS Act, the subsidies of the so-called Inflation Reduction Act and related green initiatives constitute the largest set of government infrastructure investment initiatives since the 1950s. I described the stimulative impacts of these policies in detail in “Fiscal Policy and The Fed Work at Cross-Purposes,” (Hoover, August 9, 2023). The $1.2 trillion authorized by the American Infrastructure and Jobs Act of 2021 continues to be spent, boosting government purchases counted directly in GDP. Following the surge beginning in mid-2022, growth is continuing at a diminished pace. The infrastructure initiative is creating jobs at private contractors.
The business investment responses to the CHIPS Act are multiples higher than earlier estimates by the Congressional Budget Office and Joint Tax Committee (James Lucier, “Does Bigness Bring Risk for the IRA Credits?, Capital Alpha, December 1, 2023). According to revised estimates by the CBO, JCT and others, these open-ended government subsidies are expected to continue to generate increases in investment throughout the decade.
Legislated increases in spending authorizations for defense and national security is adding directly to government purchases and GDP. Increased spending on weapons in support of Ukraine and Israel are increasing employment at a wide array of U.S. defense contractors and their suppliers.
Risks to the Forecast. Consumer spending may weaken significantly in early 2023 following the holiday season, forcing firms to step up their efforts to cut operating expenses and job layoffs. This would cut into disposable income and consumer confidence. If this happens, the impact should be noticeable in the data but would be limited insofar as businesses have efficiently managed their production processes, and kept labor inputs and inventories under control.
The key risk to the economic expansion would be if monetary policy becomes too restrictive, it would slow aggregate demand too much. So far, the economy has remained resilient and responded well to the Fed’s earlier aggressive interest rate increases. Even though the Fed raised rates aggressively in 2022, the real rate remained negative, suggesting sustained monetary accommodation.
As inflation has receded, the real Fed funds rate has risen well above standard measures of the natural rate of interest (r*) while M2 money supply continues to decline yr/yr, reducing the earlier bulge generated by the excessive monetary and fiscal stimulus of 2020-2021. Accordingly, monetary policy is in the restrictive zone.
The Taylor Rule, based on an assumption of r* = 0.5% and core PCE inflation of 3.7%, estimates that the current 5.5% Fed funds rate is in an appropriate range consistent with the Fed’s longer-run inflation target of 2%. Maintaining the Fed funds rate at 5.5% as inflation recedes further would make monetary policy more restrictive, potentially leading to an undesired slowdown in aggregate demand. Looking forward to mid-2024, if core inflation recedes to 3%, the Taylor Rule would estimate the appropriate Fed funds rate at 4.5%. However, Fed Governor Chris Waller has indicated that it would be appropriate to lower rates in response to further declines in inflation, and presumably other Fed members would agree.
Conclusion
I expect the Fed will respond to these risks appropriately and the positive economic factors will support sustained expansion.
The Fed’s Interest Rates, the Yield Curve and the Stock Market
*The yield curve, which has been inverted since June 2022, will revert back to positive in 2024 as financial markets anticipate and respond to the Fed lowering its nominal policy rate to avoid undesired restrictiveness in monetary policy as declines in inflation raise real rates.