The Fed: Soft Landing Dynamic. Hard Landing Outlook
Soft Landing Dynamic
Core CPI peaked at 6.6% YoY in September 2022 and has since fallen to 4.8% as of June 2023, a 1.8pp decline in 9 months. Over that time, the unemployment rate is basically flat at 3.6% as of the June reading versus 3.5% last September. This is exceedingly abnormal “inflation vs. labor” behavior going back to 1968. Because inflation is typically a lagging indicator, historically the inflation peak arrives inside of recession with the unemployment rate up more than 50% on average from its cycle trough.
This abnormality in the “inflation vs. labor” relationship has led to another abnormality: the direction of the real Fed Funds Rate (FFR) (defined as the effective FFR - YoY Core CPI). Historically, as YoY Core CPI peaks alongside a rising unemployment rate, the Federal Reserve is cutting rates to protect the labor market; and by the time YoY Core CPI falls 1.8pp from its peak, the real FFR is -1.4% and falling. Today, the real FFR is .3% and rising.
This is a soft landing dynamic through and through. If you’re FED Chair Jerome Powell you are ecstatic that you just got the real FFR a hair into positive territory with an upward trajectory at this point in the disinflation process. The labor side of the Fed’s dual mandate has yet to knock him off course, and from here he can allow disinflation to tighten the stance of policy while he waits for the unemployment rate to rise enough to bring wage inflation back to 3-3.5% (currently running at 4-5% depending on the measure).
But that’s all it is: a dynamic. The outlook is for a hard landing because the Fed is fighting the ghost of Arthur Burns.