Looking back several decades to the last 14 tightening cycles by the Federal Reserve’s, the Fed has managed a soft landing (i.e. successfully slowing growth and inflation without causing a recession) only twice. The other twelve tightening cycles have resulted in a recession. In other words, the odds of avoiding a recession this time around are not in the U.S. economy’s favor.
The Federal Reserve has halted the tightening cycle it began in March 2022. Since that time, the Fed raised its Fed Funds interest rate from essentially zero to 5.5%. This was a massive increase for an economy that had gotten used to very low interest rates. As a result, stock and bond prices plunged, and mortgage rates spiked to 8%.
But despite the shock of higher rates, the U.S. economy has held up relatively well. The unemployment rate is historically low. Wages are rising. Inflation is moderating and consumer spending has remained strong. Even the stock market, which suffered as interest rates rose, has now rallied back to near pre-tightening levels.
What’s the Problem?
As history shows, when the Fed starts down the path of raising interest rates to slow the economy, there is always the risk of overshooting and tipping the economy into recession. And this is where things stand now. By all accounts, lower interest rates will now be required to stimulate the economy and keep it growing.
As of the beginning of 2024, Fed officials themselves indicated they expect 75 basis points of rate reductions over the course of 2024, however bond and rate futures markets are now positioned for twice that amount. In other words, the Fed thinks that lowering rates by three quarters of a percent (to roughly 4.75%) will be enough to keep the economy afloat, but the financial markets predict that a Fed Funds rate closer to 4% will be required. And this is a level of monetary loosening that tends to coincide with a recession.
But regardless of how much policy easing will ultimately be needed to avoid recession, everyone agrees that the Fed must lower interest rates soon. Already the Conference Board’s Leading Economic Index, which is suffering a level of decline only seen in past recessions, and the personal savings rate hitting its lowest since the 2008 crash.
Good News for Stocks and Real Estate
It might seem counterintuitive that a slowing economy, and possibly even a recession, could help stock values, but that is in fact the case. The simple reason is interest rates. High interest rates—meaning the ability to earn a high risk-free return on cash—make stock earnings, and real estate income, less valuable.
Luckily, the inverse is also true. As interest rates fall, stock earnings and real estate income become more valuable and prices often rise.
There is, of course, a delicate balance here. A gently slowing economy with falling interest rates will help stocks, but a severe recession certainly will not. However, with all the talk of an economic soft landing, a severe recession does not seem very likely at this point.
In fact, the current environment of falling interest rates and inflation, coupled with strong employment and spending, could be an ideal recipe for the stock market in 2024.