managemnet company strategy managemanet Why Firms Are Struggling with the U.S. Economy’s Soft Landing

Why Firms Are Struggling with the U.S. Economy’s Soft Landing

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Optimism about the economy has grown recently. This is an overdue shift in sentiment given the FORCE in the US economy that kept going all last year when the doomsayers were calling the recession premature. A so-called soft landing is likely in play.

While that sounds like an unalloyed benefit, for companies the reality of a soft landing is more complicated. The flip side of falling inflation is reduced pricing power, lower margins, and reduced profits – which companies must navigate as they digest demand patterns, blow- our labor markets, higher interest rates, and slower growth. To navigate and remain resilient, executives must do more than knee-jerk defense spending cuts.

The fabled soft landing no longer seems like a myth.

By mid-2022, the US economy is overheating, and inflation has reached new highs. Monetary policymakers responded by aggressively raising interest rates, increasing the risk of a policy-induced recession. To avoid one, the labor market, where most of the pressure is concentrated, should ease without increasing the unemployment rate – the ultimate arbiter of the recession.

That’s considered nearly impossible by many, or “contrary to economic theory and the empirical evidence” as former Treasury Secretary Larry Summers said. put it down in June 2022.

However, seven months later, this is exactly what happened. The pressure is easing, as seen in lower job openings and slower wage growth at the same time as a drop in unemployment. As far as soft landing goes, it’s fair to say we’re in the first phase of one.

From here, the bigger question is will it continue? We expect the drivers that have allowed easing in the face of strong job creation to continue to deliver in 2023. On the demand side, labor hoarding has eased as layoffs from extremely low levels, and the pace of hiring slowed down as employers. filling most of their backlog. On the supply side, immigration has returned as pandemic constraints have faded and, while wage growth remains strong and savings have faded, labor force participation rates may continue to improve.

For a complete soft landing, interest rates must be reset.

Even if 2023 whizzes by without a recession, a continued soft landing is a higher bar. Remember that the risk of recession centers on aggressively higher interest rates, which are designed to lower inflation but which also stimulate economic activity. To get out of a high risk of recession, interest rates must be dropped back to the neutral level, where it does not restrict activity or accelerate, which is unlikely to happen in 2023.

What is stopping monetary policy from falling to neutral this year? At present, although inflation has turned into rapid disinflation, its quality is not good enough. We have seen a decline in energy and durable goods prices, while inflation in the service economy remains high. To see convincing disinflation in the service economy, wage growth must remain moderate.

But aren’t the parts of the economy already in the economy?

On the part of the economy that produces goods we hear more of the weak performance blamed on recessionary conditions. But it’s worth a closer look. Yes, consumption of real goods has been falling for the better part of two years – a dip that is historically associated with recession.

The fact remains, however, that the consumption of goods is above the pre-Covid level, and above the pre-Covid trend, even after adjusting for inflation. The declining economic demand for goods shows strange changes in the pandemic, where consumption collapses, then significantly overshoots, and then begins to fall from a high level. That was the last phase that drove recessionary sentiment, even though demand levels were the highest on record.

Yet aggregates are deceptive, and the aftermath of the pandemic has put demand patterns in disarray. For some industries, such as toys, the overshoot proved sticky and demand continued to grow. Others, such as clothing, maintain high levels of demand but pay for it without growth. For some, like furniture, the overshoot is still disappearing, and for others, like breakfast cereal, the overshoot is back — and then some.

Interpreting these unusual patterns of real demand and their stability is difficult, if necessary, for managers. However, these challenges cannot be attributed to a failed macroeconomic landing.

Meanwhile, the (much larger) economy of services does not overshoot and instead continues to normalize the pre-Covid trend, with a delay. Spending on hotels, for example, continues to grow even after adjusting for inflation. Here, too, executives need to know how long the strong tailwind will continue and when a full normalization will be achieved.

Why navigating a soft landing can be difficult for companies

Although a soft landing seems attractive, companies feel that everything is getting more difficult, for several reasons:

1. The pandemic delivered companies a moment of unusual pricing power, which has now ended.

In normal times, companies face a trade-off between rising prices and losing market share. But the pandemic is delivering excess demand at the same time as everyone struggles with supply chains. The result is the suspension of the traditional trade-off – companies can raise prices without worrying about losing market share. The macroeconomic expression of this anomaly is inflation. The microeconomic expression is high margins and stable profits.

But as the distortions lessened, demand for goods normalized. Inventories have been restocked (and overstocked in some cases). In general, the price increase has decreased. For companies, this means margins are compressed and profits are under pressure.

This is most clearly seen in categories, such as durable goods, where inflation has increased as demand and supply sputtered. Inflation in durable goods is close to zero (and negative in many goods). It can also be seen by companies throughout the economy, especially in retail, where pricing power comes and goes – and with it margin expansion and profit growth.

Slowly but surely the competitive dynamics of the pre-Covid economy are reasserting themselves, and those who previously had weak pricing power – from cars to furniture – are discovering weak pricing power. that came back.

While the service economy is not seeing a demand whiplash, it is experiencing supply-side challenges with labor efficiency and cost. These costs can be passed on as the recovery continues, driving higher margins and profits. But as demand slows, the service economy’s era of pricing power is likely to disappear as well — and with it the peak of margins and profits.

2. The labor market remains tight.

The flip side of a soft landing is the continued tight labor market. Hiring remains difficult and it is more expensive. In the short run, wage growth is likely to outpace inflation, which means wages will put pressure on margins. And in the long run, wages are likely to remain high as tight labor markets deliver real wage gains. Companies need to figure out how to pay for wage gains while passing on the costs of losing market share.

3. Capital remains expensive with high interest rates.

In addition, capital is likely to remain more expensive the interest rate is higher. In the short run, this is driven by policy rates above their neutral levels as central banks deliberately try to slow the economy. And even if the Fed eventually eases, interest rates may remain higher than ever. That’s because inflation was always very low in the years before the pandemic.

What should executives do?

The pressures on companies are the consequences of a strong macroeconomics, not a weak one. Unusual contexts require highly calibrated thinking. While cost control isn’t a bad idea, the usual recession playbook of pulling back and cutting back to fight another day doesn’t bode well for the challenges of a resilient economy.

Executives should first ask the following questions to understand the challenges that are not the product of cyclical macro trends and cannot be answered by a soft landing:

  • Is demand changing because of a sluggish economy or because the pandemic overshoot of demand is gone?
  • What changes in demand and consumer behavior are the distortions of the pandemic, and which ones are sticky?
  • How quickly will pricing competition return to their industry?
  • How can we codify and institutionalize the learnings from the pandemic on how to remain resilient for the uncertain and shifting circumstances ahead?

Then, it is worth addressing the challenges that are likely to follow a soft landing:

  • How can we hire and manage labor costs in a persistently tight labor market, but avoid overpaying because a soft landing will lead to slower wage growth?
  • Where can we invest in technology to reduce labor force and increase productivity?
  • How can we make strategic investment plans that include higher interest rates?
  • How can we respond to market pressures to focus on short-term performance without sacrificing the innovation and investment needed to navigate and capitalize on technological and social change? [Note: This is a theme we will be exploring in an article in the upcoming May/June issue of the HBR magazine.]

A soft landing remains a deceptively positive outlook for companies. Avoiding a recession is desirable, but the macroeconomic tailwind to margins and profits has become a headwind. Executives must now redouble their efforts to protect and grow both while keeping the risk of recession intact.

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