Many economists and investors had a clear narrative coming into 2023: The Federal Reserve had spent months pushing borrowing costs rapidly higher in a bid to tame inflation, and those moves were expected to slow growth and the labor market so much that the economy would be at risk of plunging into a downturn.
But the recession calls are now getting a rethink.
Employers added more than half a million jobs in January, the housing market shows signs of stabilizing or even picking back up, and many Wall Street economists have marked down the odds of a downturn this year. After months of asking whether the Fed could pull off a soft landing in which the economy slows but does not plummet into a bruising recession, analysts are raising the possibility that it will not land at all — that growth will simply hold up.
Not every data point looks sunny: Manufacturing remains glum, consumer spending has been cracking and some analysts still think a mild recession this year remains likely. But there have been enough surprises pointing to continued momentum that Fed officials themselves seem to see a better chance that the nation will avoid a painful downturn. That resilience could even be a problem.
While a gentle landing would be a welcome development, economists are beginning to ask whether growth and the job market will run too warm for inflation to slow as much as central bankers are hoping — eventually forcing the Fed to respond more aggressively.
“They should be worried about how strong the U.S. labor market is,” said Ajay Rajadhyaksha, who heads global research at Barclays. “So far, the U.S. economy has proved unexpectedly resilient.”
The Fed has lifted rates from near-zero early last year to above 4.5 percent as of last week — the fastest series of policy adjustment in decades. Those higher borrowing costs have translated into pricier car loans and mortgages, and for a while they seemed to be clearly slowing the economy.
But as the central bank has shifted toward a more moderate pace of rate moves — it slowed the speed of its increases first in December, then again this month — markets have relaxed. Rates on mortgages, for example, have come down slightly.
That’s showing up in the economy. Mortgage applications have been bouncing around, but in general they have ticked back up. New home sales are now hovering at around the same level as before the pandemic. Used car prices had been declining, but they have begun to rise at a wholesale level — which some economists see as a response to some returning demand for those vehicles.
And while retail sales and other measures of household spending have been pulling back, according to recent data, several nascent forces could help to shore up consumer demand into 2023 — with potentially big implications for the Fed’s battle against inflation.
Social Security recipients just received a sizable cost of living adjustment in their first check of 2023, putting more money in the pockets of older Americans. More than a dozen states including Virginia, California, New York and Massachusetts sent tax rebates or stimulus checks late last year. And while Americans have been working their way through the excess savings that were amassed during the early pandemic, many still have some cushion left.
The State of Jobs in the United States
Economists have been surprised by recent strength in the labor market, as the Federal Reserve tries to engineer a slowdown and tame inflation.
Adding to all of that, after more than a year in which inflation eroded consumer spending power, wage gains are finally beginning to outstrip price changes by some measures in recent months. And with employers continuing to hire, more Americans are receiving paychecks, which they could in turn spend.
“Such employment gains mean labor income will also be robust and buoy consumer spending, which could maintain upward pressure on inflation in the months ahead,” Christopher Waller, a Fed governor, said on Wednesday.
There is no guarantee that those factors will be enough to counteract the large amount of policy adjustment the Fed has done over the past year. Technology companies have already begun to lay off workers. Lower-income consumers have burned through their savings buffers more quickly than higher-income people, leaving them with less wherewithal to shop.
“I don’t think we’re re-accelerating,” said Nela Richardson, chief economist at the payroll and data company ADP. “You can have a strong labor market and slow economic growth.”
But the possibility that the economy will not grow as modestly as expected is a risk for the Fed.
Inflation has been cooling in recent months, partly because prices have outright dropped for used cars and some retail products, subtracting from overall price increases.
But if auto dealers and retail stores like Walmart and Target feel like they can stop slashing prices as demand stabilizes and they work through bloated inventories, it could keep inflation from slowing as steadily, said Omair Sharif, founder of Inflation Insights.
“The concern is now you shift to a situation where that downward pressure goes away,” he said. “Wages are still supportive of people buying more stuff.”
Jerome H. Powell, the Fed chair, acknowledged during a news conference last week that some of the drag on inflation from goods could be “transitory,” meaning that it will fade away. That is, in part, why central bankers are closely watching what happens in other sectors, particularly services.
One major service cost — rent — does look poised to decelerate this year. But both the extent and the timing is enormously uncertain: Some economists think that rent increases will slow in official inflation data within the coming months, while others are expecting the change to come much later.
Lael Brainard, the Fed vice chair, suggested in a recent speech that rent inflation might not decline until the third quarter of 2023, which stretches from July through September.
The trajectory for other service prices, from child-care to restaurant meals, is expected to hinge on what happens with the labor market. Wages tend to be a major cost for service companies, and if pay is climbing swiftly, businesses may charge more. Workers who are taking home bigger paychecks may be able to keep spending through those cost increases.
To be sure, inflation and wage growth have slowed in recent months even with very strong hiring. Fed officials have embraced that, and they have made clear that they’re focused on what happens with inflation rather than aiming for a specific increase in unemployment.
But several have expressed doubts that wage and price moderation can continue with labor demand so robust and a jobless rate at 3.4 percent, the lowest since 1969. Companies will be left competing for a limited pool of workers. And given that today’s disinflation is coming partly from product price declines that are not expected to continue indefinitely, slowing down services prices is crucial.
“The services sector, really, except for housing services, is not really showing any disinflation yet,” Mr. Powell said this week.
The question for the Fed is how much more policy adjustment is needed to ensure that the economy and inflation return to a sustainable pace. The central bank has forecast that it will make two more quarter-point rate increases.
John C. Williams, the president of the Federal Reserve Bank of New York, on Wednesday indicated that quarter-point moves were likely to remain the norm, but he suggested that rates might have to adjust by more if demand and price increases stay elevated.
“Demand in our economy is much stronger right now than you might expect in a regular, pre-pandemic situation,” Mr. Williams said, attributing that to fiscal support, a strong labor market and other factors. How high rates must climb in order “to be sufficiently restrictive has got to be influenced by that.”
Although many business leaders are still watching consumers warily, some of them have suggested that impediments to growth are fading. The S&P 500 as a whole has been recovering over the past six months, a sign that investors see a sunnier outlook on the horizon.
Ryan Marshall, chief executive officer of the homebuilder Pulte Group, suggested in an earnings call last week that the housing market was noticeably improving.
“Despite the higher rate environment dominating the national conversation, we saw buyer demand improve as the fourth quarter progressed and can confirm this strength continued through the month of January,” he said.
And David B. Burritt, the chief executive of U.S. Steel, said in a recent earnings call that he expected “prices will be sustainable and higher” in the longer-term as headwinds to growth fade.
“We’re in this transitional period with a lot of uncertainty,” he said, “and frankly I think a lot of people think the Fed is doing a lot better job on this soft landing than what was expected.”
Neil Dutta, head of U.S. economics at Renaissance Macro, said that the re-acceleration signs in the economy were “undeniable,” and that inflation could get stuck at unusually high levels as a result — forcing the Fed to keep rates high for longer than expected.
“They’ve been raising rates for a while,” he said. “All they have to show for it is an unemployment rate at 3.4 percent.”