Data as of September 30, 2023. Sources: Macrobond, and Bureau of Labor Statistics.
However, like the flight mentioned above, the only thing more unnerving than a bumpy landing is no landing at all. In this no-landing scenario, to which we today place roughly 25% odds, the above-trend economic growth keeps the risk of reaccelerating inflation on the front burner. A tight labor market threatens to push wages higher, which may ultimately need to be passed through to end prices, absent a surge in productivity. The Fed would be more inclined to maintain a higher-for-longer policy stance. Instead of cutting rates by mid-2024, continued stronger-than-expected economic growth could lead the Fed to err on the side of keeping rates elevated through next year. The near-term burst of economic activity increases the risk of a harder landing further down the road, as the lagged effects of higher rates weigh on consumers, small businesses, and the real estate market.
Tempering the no-landing risks
Despite increasing the odds of continued economic strength in a no-landing scenario, we still see it as more likely that the U.S. economy slows into the end of the year. In this soft-landing scenario, to which we place approximately 50% odds, we see growth stalling in the fourth quarter, as payback for the unusual strength in the third quarter. We expect growth to pick up modestly in 2024 to a below-trend growth rate of 1.2% for the year. Crucially for the wage outlook, the strong hiring activity by U.S. firms has been met by even stronger labor force growth, so as those jobs have been filled, wage growth has continued to slow.
Several headwinds are building that we expect to slow but not halt the pace of consumer spending. Consumer savings have been drawn down through the year and are well below trend for much of the population—though data suggest it still remains in aggregate meaningfully above prepandemic levels due to higher income groups. Resumption of student loan payments and higher gasoline prices could weigh on lower-income consumers. Credit card borrowing rates are at an all-time high, and data show payments on balances declining and delinquencies rising, the latter from very low levels. Housing affordability, for renters and owners, is the lowest in decades. Labor strikes and a possible government shutdown pose short-term risks.
These headwinds could certainly weigh on the economy more heavily than we expect, resulting in a mild recession. However, a tight labor market keeps the odds of a recession in check. The manufacturing economy—domestically and globally—has been in decline for the better part of this year but is showing signs of bottoming. Even with the strong third-quarter growth, inflation continues to decelerate. Housing market data suggest the inflationary pressure from owners’ equivalent rent will continue to recede, while purchasing managers indices for services and manufacturing show significant disinflation in the pipeline. If inflation continues to fall, we believe the Fed should be in a position to cut rates even with strong economic growth. We experienced economic growth of 2%–2.5% between 2015 and 2019 without inflation building. In addition, if inflation continues to decline as we expect, the Fed risks yet another misstep as policy will become unnecessarily tight, unless it begins to cut rates.
The shift in the balance of economic risks is translating into higher interest rates. We see this reflected in recent market activity, as the 10-year Treasury yield climbs toward 5%—the highest since 2007. The more resilient economic activity has driven real rates higher. The supply/demand backdrop has also deteriorated alongside increased federal borrowing and fewer willing buyers (e.g., the Fed continuing quantitative tightening, as well as reduced demand from international investors).
Figure 3: 10-year Treasury yield surges toward 5%
Current yield on 10-year U.S. Treasury note