Economy

The United States appears to be avoiding a recession. What could go wrong?

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With inflation falling, unemployment low and the Federal Reserve signaling that it may soon begin cutting interest rates, forecasters are becoming increasingly optimistic that the economy can American to avoid a recession.

Wells Fargo last week became the latest major bank to predict that the economy would experience a soft landing, slowing gently rather than stopping suddenly. The bank’s economists have been forecasting a recession since mid-2022.

Yet if forecasters were wrong when they predicted a recession last year, they could be wrong again, this time in the opposite direction. The risks economists have highlighted in 2023 have not gone away, and recent economic data, while remaining mostly positive, suggests cracks beneath the surface.

Indeed, the same day that Wells Fargo reversed its call for recession, its economists also published a report highlighting signs of weakness in the labor market. Hiring has slowed, they noted, and only a handful of industries are responsible for much of the recent job gains. Layoffs remain low, but workers who lose their jobs have a harder time finding new ones.

“We’re not out of the woods yet,” said Sarah House, one of the report’s authors. “We still think the risk of recession is still high.”

Ms. House and other economists have stressed that their recent optimism has good reason. The economy has weathered rapidly rising interest rates much better than most forecasters expected. And the surprisingly sharp slowdown in inflation has given policymakers more leeway: If unemployment starts to rise, for example, the Fed could cut rates to try to prolong the recovery.

If a recession occurs, economists believe it could happen in three main ways:

The main reason economists predicted a recession last year is because they expected the Fed to cause one.

Fed officials have spent the past two years trying to curb inflation by raising interest rates at the fastest pace in decades. The goal was to curb demand just enough to bring down inflation, but not so much that companies start carrying out mass layoffs. Most forecasters – including many within the central bank – believed that such careful calibration would prove too complicated and that once consumers and businesses began to withdraw, a recession would be almost inevitable.

It is still possible that their analysis is correct and only the timing is wrong. It takes time for the effects of rising interest rates to be felt in the economy, and there are reasons why the process might be slower than usual this time around.

Many companies, for example, refinanced their debt during the period of extremely low interest rates in 2020 and 2021; only when they need to refinance again will they feel the consequences of higher borrowing costs. Many families were able to ignore higher rates because they had accumulated savings or paid off debt earlier in the pandemic.

However, these safety margins are eroding. Extra savings are shrinking or already gone, by most estimates, and credit card borrowing is setting records. Rising mortgage rates have slowed the real estate market. Student loan payments, which had been suspended for years during the pandemic, have resumed. State and local governments are cutting budgets as federal aid dries up and tax revenues decline.

“When you look at all the supports that consumers have had, a lot of them are fading,” said Dana M. Peterson, chief economist at the Conference Board.

The manufacturing and real estate sectors have experienced recessions before, with output contracting, Ms. Peterson said, and more generally, business investment is lagging. Consumers constitute the last pillar of the recovery. If the job market weakens even a little, she added, “that might wake people up and make them think, ‘Well, maybe I won’t get laid off, but I might get fired, and at least I won’t get fired too.’ bonus” and reduce their expenses accordingly.

The main reason economists have become more optimistic about the possibility of a soft landing is the rapid cooling of inflation. By some short-term measures, inflation is now barely above the Fed’s long-term goal of 2%; Prices of some physical goods, like furniture and used cars, are actually falling.

If inflation is kept under control, this gives policymakers more room to maneuver, allowing them to cut interest rates if unemployment starts to rise, for example. Fed officials have already indicated they plan to start cutting rates this year to keep the recovery on track.

But if inflation picks up, policymakers could find themselves in a difficult situation, unable to cut rates if the economy loses momentum. Or worse yet, they might even be forced to consider another rate hike.

“Despite strong demand, inflation continues to fall,” said Raghuram Rajan, an economist at the University of Chicago Booth School of Business who has held senior positions at the International Monetary Fund and the Bank of America. ‘India. “The question now is: In the future, will we be as lucky?

Inflation fell in 2023 in part because the supply side of the economy has improved significantly: supply chains have largely returned to normal after the disruptions caused by the pandemic. The economy also received an influx of workers as immigration rebounded and Americans returned to the workforce. This meant that companies could get the materials and labor they needed to meet demand without raising prices as much.

However, few expect a similar resurgence in supply in 2024. This means that for inflation to continue to fall, there may need to be a slowdown in demand. This could be particularly true in the services sector, where prices tend to be more closely linked to wages – and where wage growth has remained relatively strong due to demand for workers.

Financial markets could also make the Fed’s job more difficult. Stock and bond markets rallied late last year, which could effectively undo some of the Fed’s efforts by making investors feel wealthier and allowing businesses to borrow more cheaply. This could help the economy in the short term, but force the Fed to act more aggressively, increasing the risk of causing a recession down the road.

“If we do not maintain sufficiently tight financial conditions, there is a risk that inflation will resume and reverse the progress we have made,” Lorie K. Logan, president of the Federal Reserve Bank of Dallas, warned this month . in a speech at an annual conference for economists in San Antonio. As a result, she said, the Fed should leave open the possibility of another interest rate hike.

The economy had some lucky moments last year. China’s weak recovery has helped keep commodity prices in check, which has contributed to slowing U.S. inflation. Congress avoided a government shutdown and resolved the debt ceiling issue with relatively little drama. The outbreak of war in the Middle East had only a modest effect on global oil prices.

There is no guarantee that the luck will continue in 2024. The expanding war in the Middle East is disrupting shipping lanes in the Red Sea. Congress will face a new government funding deadline in March after passing a stopgap spending bill on Thursday. And new threats could emerge: a deadlier strain of coronavirus, a conflict across the Taiwan Strait, a crisis in a previously obscure corner of the financial system.

Any of these possibilities could disrupt the balance the Fed is trying to strike by causing inflation to rise or demand to collapse – or both.

“This is what, if you’re a central banker, keeps you up at night,” said Karen Dynan, a Harvard economist and former Treasury Department official.

Although such risks still exist, the Fed has little margin for error. The economy has slowed significantly, leaving less room to maneuver in the event of another hit to growth. But with inflation still high – and memories of high inflation still fresh – the Fed may find it difficult to ignore even a temporary rise in prices.

“There is room for error on both sides that would ultimately lead to job losses,” Ms. Dynan said. “The risks are certainly more balanced than they were a year ago, but I don’t think that gives decision-makers much more comfort.”

Audio produced by Patricia Sulbaran.