After a year of excessive gloom, the recent improvement in sentiment is a sharp turn. Equity markets have moved away from their lows while fears of inevitable recession have been replaced by optimism about avoiding one.
Having emphasized the economy’s resilience throughout last year, this shift in sentiment is warranted in our view–but the new optimism should be for the right reasons. Rapid disinflation, widely predicted and likely to continue, will not be enough to unwind tight monetary policy, which is driving recession risk.
A better reason for soft-landing optimism is the labor market and, critically, slowing wage growth. Even with high interest rates or slower-than-expected disinflation, a soft landing may remain on track if wage growth eases and overheated job openings fall without pushing up the unemployment rate. Think of it as a successful reallocation of labor from weak sectors to stronger ones.
Prominent naysayers, such as Larry Summers, all but ruled out a soft landing last June. Yet, that is precisely what has been happening. The first stage of a soft landing is playing out as job openings have eased while unemployment fell. There is no guarantee the journey to such a graceful easing continues in 2023–let alone that policy can begin to normalize in 2024–but optimists can credibly pin their hopes on several labor market dynamics this year.
Soft-landing optimism and disinflation
The recent euphoria about inflation’s peak and fast fall–which was widely predicted but delayed due to energy shocks–does not make for a well-grounded soft-landing argument. In fact, just as the fearful narratives of a 1970s-style regime break were overdone on the way up, now the significance of falling inflation is also overstated.
Of course, falling inflation is important and welcome–but it is unlikely to lead to a loosening of monetary policy in 2023. The Fed itself has said clearly that they expect to keep the policy rate above 5% at the end of 2023 even as they expect inflation to slow sharply to 3.1%. While those plans can change, with the most serious challenge to the inflation regime in decades and reputations to defend, central bankers are less likely to fold to fears of economic weakness than in the past.
It’s not just the size or speed of the fall–the quality of disinflation also matters to get monetary policy to ease. And much of the fall so far is not of the highest quality. Rather, it’s driven by sharp idiosyncratic falls in durable goods and energy. The quality problem will be clear in the middle of 2023 when headline inflation will likely fall below core inflation. But it’s the latter that needs to fall convincingly.
A durable reduction of core inflation requires a meaningful moderation in wage growth–despite tight labor markets. That is the key to today’s soft landing.
A better reason for optimism: The labor market
A soft landing has been widely dismissed by leading doomsayers. Larry Summers wrote in early June 2022 “that bringing down job openings without increases in unemployment is at odds with both economic theory and the empirical evidence”. And it is certainly true that in U.S. history falls in job openings are mirrored by rising unemployment, which is the only certain arbiter of recessions.
However, the second half of 2022 clearly contradicted that. The first stage of the inconceivable soft landing has played out: job openings fell, wage growth moderated, while the unemployment rate actually dropped to a multi-generation low. Some labor was reallocated, some jobs were filled by new workers, and some jobs were determined to be unneeded–each allowed the labor market to ease in the face of strong labor demand.
Can the second stage of a soft landing succeed? What would it take to continue to beat the odds and let the economy escape recession in 2023? Optimists can pin their hopes on several labor market dynamics that we find encouraging.
First, the intensity of hiring has slowed. The frenetic pace at which firms were trying to bring on workers has moved down as panic over missing out on demand has ebbed. As restaurants have caught up (somewhat) on staffing, their desperation–and with it, the wage surge–has eased.
Second, labor hoarding is ebbing. One remarkable feature of the labor market in 2021 and (much of) 2022 was the exceptionally low level of layoffs. Firms that feared they couldn’t hire the workers they wanted were loath to let anyone go. As hiring has gotten easier and demand eased, so has that fear–and layoffs are picking up.
Third, labor supply continued to return. Labor supply would surely have been stronger absent the pandemic, but prime-age participation eventually showed strength as the pandemic faded. And there remains an opportunity for somewhat better participation to help ease the tightness in labor markets.
Each of these dynamics can help ease wages without a rise in unemployment. And if wage growth can moderate, the second stage of a soft landing is done.
A complete soft landing requires monetary policy to normalize
Even if the above comes to pass in 2023 and the economy squeaks by without recession, a third stage is required to complete a soft landing and exit a period of uncomfortably high recession risk.
That third stage is about normalizing monetary policy by lowering rates so they are not a persistent headwind to growth. To do this, the Fed must believe the labor market has eased enough to durably achieve its inflation target. If they can, a complete soft landing will be accomplished.
This benign scenario of moderating policy likely would not begin until 2024–and the Fed would move slowly if labor markets remained strong, fearing upside inflation risk more than downside. Thus, it could be well into 2025 or beyond for a complete soft landing to be accomplished.
Today’s confluence of exceptional circumstances makes predicting the cycle, and recession, even more fraught than it normally is. Add to that the possibility of new shocks (this time last year war in Europe was but an implausible risk) and a soft landing may sound like wishful thinking.
Against the odds, we’re moving towards a soft landing–and we would not be surprised if 2023 ends with the labor market still strong and wage growth eases.
Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
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