The goldilocks narrative has become consensus for the US. Growth is slowing but the economy is not slipping into a recession; the labour market is cooling but is still strong and inflation continues to ease. In this soft-landing scenario, the central bank will be able to cut official rates sometime this year.
Several factors explain why the US economy has been so resilient. Consumers and businesses have been insulated to some degree from the impact of higher interest rates. When rates were low, home buyers had obtained 30-year fixed rate mortgages and companies had renewed their loans. Fiscal stimulus has also given a sizeable boost to consumers’ savings and three big spending packages on infrastructure, clean tech and semiconductors have also supported demand. Finally, as an energy exporter, the US has benefitted from higher oil prices. That inflation has continued to ease is because there was also growth in supply capacity. Supply chain disruptions that occurred during the pandemic were resolved, and the labour force expanded thanks to a higher participation rate and, above all, an increase in immigration.
Central bankers have encouraged markets to embrace this soft-landing optimism. Despite inflation surprising to the upside during the first quarter, the Federal Reserve was remarkably dovish at its last meeting and maintained its plan to cut interest rates three times this year. But can this goldilocks situation continue? Consensus thinks so. The median growth forecast for the US is 2.2% for 2024, yet inflation is seen receding to 2.1% using the Fed’s preferred gauge, the PCE Index (Personal Consumption Expenditure Index). We find it hard to believe that the Fed will be able to pursue its ambitions to cut rates three times this year. With the labour market tight and service price inflation appearing sticky, we think that this outcome remains unlikely. The only way this seems plausible would be if the economy slipped into a recession and inflation dropped as a result.
Several factors that supported growth in the past are now fading. Consumer savings are almost back to pre-pandemic levels and will no longer support consumer spending. At some point, higher rates will start to bite as debt rolls over and companies renew a large portion of their debt during the second half at much higher rates. Fiscal policy has turned less supportive. And while the ripple effects of the commercial real estate slump in the US have been contained, it shows that we have yet to see the lagged effect of higher interest rates.
Other countries are not in such good shape. Growth in the euro area was anaemic last year, partly reflecting the impact of tighter monetary policy, and GDP probably grew 0.1% in the first quarter of 2024 after stagnating in the fourth quarter of 2023. Although the PMI readings for the bloc have shown improvement, the index remains in contractionary territory. In addition, heightened geopolitical risks and weak global demand could continue to weigh on growth, particularly in Germany. The upward revision to Japan’s fourth-quarter GDP growth indicates the economy was not in a technical recession after all, but the recovery has been underwhelming and domestic demand has fallen for a third straight quarter. Finally, China is downshifting onto a slower growth path sooner than expected. The post-COVID rebound was lacklustre, the property market is in a slump and Beijing’s stimulus plan has been disappointing.
Time will tell whether central banks will succeed in pulling off a goldilocks scenario, but the truth of the matter is that the hardest part is yet to come, which is depending on if, when and by how much they manage to cut interest rates.
Date of report: April 10th 2024