Soft Landing Scenario Assumptions

Genevieve Signoret & Delia Paredes

(Hay una versión en español de este artículo aquí.)

What follows is a slightly edited excerpt from Quarterly Outlook 2023–2025: It All Hinges on Rates.

In previous blog posts, we told you that high long-term rates are hurting asset valuations (equity and fixed assets), and that they’re high because Fed officials and the public fear that inflation (and therefore rates) may persist high or even go higher. And we showed you data and told you a story to persuade you that there’s a sound basis for those worries—so much so that, later in this series, we’re going to narrate for you a risk scenario called Roller Coaster in which those worries are borne out. But Roller Coaster is not our base case. To build our base case, we assume that rates peak soon and then trend down. This rate reduction prevents things from “breaking”. In other words, the economy experiences a Soft Landing.

In both cases, in Mexico, the friendshoring narrative that, we suspect, has been supporting the Mexican peso, fades some on electoral uncertainty, weakening rule of law, rising violence, concerns over Pemex, unreliable energy supplies, and the knowledge that 2025 will bring a fiscal adjustment.

Soft Landing Assumptions

We assume just one thing, which is that rates come down. But this assumption actually summarizes a longer list of assumptions—namely, the fading of all factors idiosyncratic to the post-pandemic era keeping rates high. Let’s look at these more detailed assumptions now, one by one.

The lagged effects of fiscal stimulus fade

During and shortly after the worst of the pandemic, recall, the U.S. government passed huge fiscal stimulus packages. In our story explaining today’s high long-term rates, we mentioned three channels through which the lagged effects of that stimulus are pushing rates up. First, because not all stimulus money has been spent yet, nominal aggregate incomes remain inflated. Second, the stimulus packages have forced the Treasury to issue more and more debt. And third, the stimulus has boosted worker bargaining power.

In Soft Landing, we assume that two of these lagged effects from the Covid-era stimulus will continue to fade: inflated nominal aggregate incomes and strengthened worker bargaining power.

Post-pandemic labor hoarding fades

We’ve laid out our belief that the pandemic-era shutdown caused labor shortages so severe that, today, firms still tend to hoard labor. Now we are starting to see layoffs in professional services, and job openings are in decline. So, in Soft Landing, we assume that employers will soon start to feel comfortable letting go of their excess workers.

People start to move

We’ve pointed out that Americans are holding on to their homes and, with them, their rock-bottom mortgage rates. We know that this can’t last forever and, in Soft Landing, assume that, soon, and gradually, existing home sales will start to pick up. This weakens the demand for construction workers, easing up on consumer service demand and thus lowering core inflation rates. This progress in slowing core inflation down soothes both Fed officials and the public. Long-term rates come down.

People get used to being free

Earlier, we shared our belief that one factor explaining strong consumer demand for services such as Taylor Swift concerts, travel, eating out, and the like, is that so much of this demand got pent up during the shutdown. But, we all know that, someday, folks are going to become used to their freedom and no longer consume services with such frenzy. Hence, we assume in our base case that the boost to service consumption from the post-Covid reopening will fade.

Bidenomics and high debt issuance continue

Of course, the Treasury has to pay its bills, so its strong issuance of debt securities will go on. Also, the stimulus packages aimed at greening the economy that we call “Bidenomics” will continue to push up on demand. So, rates will fall, we assume, but not all the way the floor. Furthermore, they have not yet peaked. We think they’ll go back up to 5% or beyond before turning down into a sustained decline.

Previous excerpts from Quarterly Outlook 2023–2025: It All Hinges
on Rates:

1. Summary
2. Long-term rates and equity valuations
3. Rates, Covid and real estate valuations
4. Why have US long-term rates trended up? Hypothesis 1: Debt issuance
5. Why have US long-term rates trended up? Hypothesis 2: Tight policy
6. Why have US long-term rates trended up? Hypothesis 3: Investor inflation worries
7. Why is US nominal income unexpectedly high?
8. Momentum: Recap
9. What about growth in Mexico?