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When the interest rates were rapidly raised by the Fed and the ECB in 2022 and early 2023, it was widely expected that a recession would begin no later than mid-2023. The European economy has contracted somewhat (although it is now growing again), but the US economy has been growing at 3% or more since mid-last year. Additionally, inflation has remained on the high side throughout this period. Only in the last few weeks have weaker figures emerged from the US. The American labor market also seems to have become slightly less tight, and the latest inflation figure was somewhat better for the first time this year.
The markets immediately reacted to this, reasoning that the high interest rates are finally starting to take effect. The major difference from a few quarters ago is that, thanks to the disappearance of various supply-side bottlenecks and despite the high growth, inflation has significantly decreased. Although the official target is 2%, there has already been a decline to around 3%.
Now, if the nominal interest rate remains the same and inflation decreases, the real interest rate rises. This has happened in recent quarters, and it increasingly slows down the economy. Since growth is already declining according to recent figures and inflation doesn't need to decrease much further, unchanged policy could lead to 'overkill'. Hence, there is now more expectation of interest rate cuts by the Fed. If this is well-timed, the growth of the US economy could be slightly above 2% this year and around 1.5% next year. This is exactly what is needed to bring inflation further down without the economy nearing a recession. This so-called 'soft landing' or 'Goldilocks scenario' is favorable for stocks, gold, and bonds, and somewhat unfavorable for the dollar. A similarly favorable outlook is expected for the European economy, although growth in Europe is much lower.
However, looking at the past, achieving a soft landing has rarely been successful, and when it was, it didn't last long. The dangers we currently see are mainly:
- After three quarters of higher-than-expected growth, a few weeks of weaker figures don't mean much. This could also be due to seasonal adjustments or abnormal weather conditions. We will only have more certainty after two months.
- So far, employment, the total number of hours worked, and wages are increasing significantly. It is uncommon for growth to decline much under these circumstances, especially with falling inflation and thus an increase in real disposable income.
- Typically, the incumbent government manages to maintain economic growth until the elections.
Therefore, it wouldn't surprise us if the markets are now overreacting. Interest rates will likely fall over the course of this year and next year, but probably less than the markets are currently pricing in. We see growth, wage increases, and inflation falling too slowly for that. This will certainly have consequences for the markets, also because government finances, especially in the US, are rapidly deteriorating, and this would not be a favorable development for most emerging markets either.
