A year ago, a recession was seen as a foregone conclusion – and yet the Fed appears to have successfully lowered inflation without causing a recession. Many of the negative forecasts follow a pattern of downplaying the strength of the US economy, mostly because they are based on historical models and precedent, not situational and idiosyncratic contexts. While the soft landing may be progressing with promise, it is not a final state – a new disequilibrium will emerge. Leaders cannot wait for macroeconomic certainty or stability. Instead, they need to recognize that the macroeconomy remains unknown in the models – and that what matters is judgement.
The US economy has once again defied the doomsayers. More than a year has passed since a recession was seen as a foregone conclusion and a “soft landing” was declared almost impossible. But now, the soft landing is progressing well, though not completely: The Fed has found success in lowering inflation without triggering a recession. The labor market, the only reliable evidence that the economy is in recession, cooled without pushing up the unemployment rate.
While this is good news, the lingering uncertainty surrounding the economy has many leaders confused — and comes at a cost for those looking to get ahead of the recession. This uncertainty will continue. What happens after the soft landing (if indeed it can be completed)? To answer this question, let’s look at why recession calls are wrong and what’s coming.
Recession Predictions, Did Not Come True
Like the pandemic, when doomsayers predict a “Great Depression,” a lot of negativity has dominated public discourse in the last year and a half. Some leaders predict that “storm” will hit the economy soon; OTHERS ruled out even the possibility in a soft landing.
But as the graphic below shows, that’s exactly what happened over the past 16 months. Job openings are down from their highs as companies feel less burdened, and quit rates are down because workers feel less inclined to jump – while hiring (“payrolls”) continues at a brisk pace. While the unemployment rate remains near 60-year lows it shows no sign of a recession.
What went wrong, or, more precisely, what went right?
Many of the negative forecasts follow a pattern of downplaying the strength of the US economy, mostly because they are based on historical models and precedent – not situational and idiosyncratic context. Consider the following four manifestations of strength:
- Stability of the labor market. The widespread assumption is that monetary policy will drive labor demand collectively underwater. Instead we see pockets of weakness, masked by overall strength. Significant layoffs have occurred where hiring has been excessive (eg, tech) but in other sectors (eg, services) hiring is still ongoing and remains strong. Laid-off workers found new jobs. Strength is found in the unusual economic diversity of recessionary sectors with emerging ones.
- Consumer strength. Growing layoffs, inflation eating into household budgets, and falling portfolios weakening balance sheets led to predictions of a spending collapse. But context matters. Balance sheets have buffers, including cash. And while individual budgets are being squeezed, overall incomes continue to grow rapidly as hiring continues, giving consumers a boost. The aggregate downdraft did not occur.
- Housing stability. The common fear is that rising interest rates will bring the housing market to its knees – delaying construction activity, lowering prices, or even, as predicted by some doomsayers, causing another housing-centered recession. But these accounts ignore the fact that the activity remains precisely because housing inventory is low. As a result, higher rates dampened – rather than stifled – housing activity. Housing started and prices fell, and transactions fell, but they recovered and rose again.
- Stability of the financial system. Another common fear is that the Fed will hike until something breaks. The idea that the financial system is collateral damage to higher rates is as absurd as breakdown of SVB is shown. But the danger of contagion is overstated, while the ability of policymakers to prevent it is understated.
Better than expected results share a pattern. Each concern has merit but is considered too trivial. Idiosyncratic, contextual, and situational drivers are more important than what historical relationships – and the models based on them – say about these sectors.
A lesson that cannot be learned often enough, it seems, is that reliance on macroeconomic models remains too strong. Cycle idiosyncrasies call for judgment rather than accurate predictions. Meanwhile, doomsaying is often amplified because the microphone reliably transmits the most doomy voices.
The Road Ahead
Economists often unhelpfully frame the business cycle as a “transition to equilibrium.” (The aviation analogy of a “soft landing” is equally guilty.) In reality, we are constantly shifting from one idiosyncratic disequilibrium to another, meaning executives cannot rely on forecasts. New idiosyncratic drivers will often provide new conditions that are not readily captured by models.
So, what is the new disequilibrium?
Even if the first stages of the soft landing are successful, dismissing a recession would be a mistake. This remains a possible, even plausible, outcome (and over time an inevitable one). Fiscal policy has one foot on the brake. Real shocks often end a cycle, especially when growth is already slow and the economy is thus weaker, and financial stresses, such as bank failures, can arise unexpectedly. In consideration of three types of recession Risk remains essential, but we still view the risk of recession in the near term as lower than consensus.
A re-acceleration is more likely, because a strong economy has successfully coped with this period of weak (but not recessionary) growth. However, such re-acceleration can play out in different ways – some welcome, some not.
Scenario 1: A Re-run of the Overshooting Economy
If demand increases rapidly and exceeds the capacity of the economy (think available labor, capital, and known processes), another bout of inflation is likely. This requires a new round of monetary tightening with all the risks we mentioned above.
However, it can be done not then point to the “inflation regime break” – the false narrative of the past two years that the US economy has seen a structural return to inflation. This will mean another bout of cyclical inflation that will come (and go) with a mismatch in demand and supply.
Scenario 2: A Just Economy
If demand grows in line with the economy’s capacity, expansion can proceed at acceptable growth rates without renewed inflationary pressure. Fiscal policy may ease from its very tight stance to a more neutral stance – until a shift to a new disequilibrium emerges.
Scenario 3: A Better Than Good Economy
We know it comes when economic capacity grows faster than demand, facilitating rapid growth without concomitant cyclical inflation. While strong capital formation and strong labor participation help accelerate this scenario to a degree, it is the cause of an acceleration of productivity growth.
Will it happen and is it possible?
Many are excited to pencil in higher growth courtesy of ChatGPT and other AI applications – but not very fast. The mere availability of labor does not guarantee faster productivity growth; think about the tech that just fuel. the spark usually comes in the form of tight labor markets. When firms are forced to substitute capital for labor, they tend to do more of it. If they can’t hire the next worker, they change their processes.
Such continued tightening of the labor market and its benefits are a realistic prospect. However, leaders must remain cautious about the size and speed of such gains. Large productivity gains at the macroeconomic level come gradually, not suddenly, and their size is often exaggerated – as we saw in the pandemic, when analysts rush to pencil in an additional 1 percentage point of growth which was not fulfilled.
The benefits of such a scenario are broader than relatively high growth. Tight labor markets create real wage growth across the income distribution, and the biggest winners tend to be at the bottom of the distribution. It creates opportunities for career advancement and job creation for those who have few opportunities or struggle to get on the job ladder, and it pulls into the labor market those who might otherwise have left.
. . .
While the soft landing may be progressing with promise, it is not a final state – a new disequilibrium will emerge. Leaders cannot wait for macroeconomic certainty or stability. Instead, they need to recognize that the macroeconomy remains unknown in the models – and that what matters is judgement. Sad headlines will continue, and economic models will provide a flat view of the world that is missing critical context. Leaders must use the same skills they use every day to lead their companies through the uncertainty of navigating the macroeconomy. They must avoid both overreacting to the latest piece of data and prepare for an unchanging view of the future.
For companies, the challenges of tight economyincluding margin pressure, as well as higher, but healthy interest rates, are likely here to stay – but they are better than the alternative of recession. Facing these challenges head on means more capital for labor replacement, more invention, and more technology absorption. Each of these forms the foundation of a better-than-ideal economic scenario.