The US appears to be avoiding a recession. What can go wrong?

With inflation falling, unemployment low and the Federal Reserve signaling that it will soon cut interest rates, forecasters are becoming increasingly optimistic that the US economy can avoid a recession.

Wells Fargo last week became the latest major bank to predict that the economy will achieve a soft landing, with the economy slowing gently rather than screeching to a halt. Economists at the bank have been predicting a recession since mid-2022.

But if forecasters were wrong when they predicted a recession last year, they could be wrong again, this time in the opposite direction. The risks that economists highlighted in 2023 have not gone away, and recent economic data, while still mostly positive, has suggested some cracks beneath the surface.

On the same day that Wells Fargo reversed its call for a recession, its economists also released a report pointing to signs of weakness in the labor market. Hiring has slowed, they noted, and just a handful of industries are responsible for much of the recent job growth. Layoffs remain low, but workers who lose their jobs have a harder time finding new ones.

“We're not out of the woods yet,” said Sarah House, author of the report. “We still think the recession risk is still high.”

Ms. House and other economists have emphasized that there are good reasons for their recent optimism. The economy has weathered the rapid rise in interest rates much better than most forecasters expected. And the surprisingly strong slowdown in inflation has given policymakers more room to maneuver. For example, if unemployment starts to rise, the Fed could cut rates to try to prolong the recovery.

If a recession does happen, economists say there are three main ways it could happen:

1. The postponed delay

The main reason economists predicted a recession last year is that they expected the Fed to cause one.

Fed officials have spent the past two years trying to rein in inflation by raising rates at the fastest pace in decades. The goal was to suppress demand just enough to reduce inflation, but not so much that companies would initiate widespread layoffs. Most forecasters – including many within the central bank – thought such careful calibration would prove too difficult and that once consumers and businesses began to pull back, a recession was all but inevitable.

It is still possible that their analysis was correct and that only the timing was wrong. It takes time for the effects of higher interest rates to ripple through the economy, and there are reasons the process may be slower than normal this time around.

For example, many companies refinanced their debt during the period of ultra-low interest rates in 2020 and 2021; only when they have to refinance again will they feel the burden of higher financing costs. Many families were able to shake off higher rates because they had built up savings or paid off debt earlier in the pandemic.

However, those buffers are eroding. By most estimates, the excess savings are declining or have already disappeared, and credit card borrowing is setting records. Higher mortgage rates have slowed down the housing market. Student loan payments, suspended for years during the pandemic, have resumed. State and local governments are slashing their budgets as federal aid dries up and tax revenues decline.

“If you look at all the support that consumers have had, a lot of it is fading,” said Dana M. Peterson, chief economist for the Conference Board.

The manufacturing and housing sectors have already experienced recessions, with production shrinking, Ms. Peterson said, and business investment more broadly lagging. Consumers are the last pillar holding back the recovery. If the labor market weakens even a little bit, she added, “it could wake people up and think, 'Well, I might not get fired, but I might get fired, and at least I'm not going to be like this. growing up'. bonus,” and reduce their expenses accordingly.

2. The return of inflation

The biggest reason economists have become more optimistic about the possibility of a soft landing is the rapid cooling of inflation. By some shorter-term measures, inflation is now barely above the Fed's long-term target of 2 percent; prices for some physical goods, such as furniture and used cars, are even falling.

When inflation is under control, policymakers have more room to maneuver, allowing them, for example, to cut interest rates if unemployment starts to rise. Fed officials have already indicated they expect to start cutting rates sometime this year to keep the recovery on track.

But if inflation picks up again, policymakers could find themselves in a tight spot, unable to cut rates as the economy loses momentum. Or worse, they could even be forced to raise rates again.

“Despite strong demand, inflation is still falling,” said Raghuram Rajan, an economist at the University of Chicago Booth School of Business who has held top positions at the International Monetary Fund and the Bank of India. “The question now is: will we be so lucky in the future?”

Inflation fell in 2023 partly because the supply side of the economy improved significantly, with supply chains largely returning to normal after the disruptions caused by the pandemic. The economy also received an influx of workers as immigration recovered and Americans returned to the labor market. That meant companies could get the materials and labor they needed to meet demand without raising prices too much.

However, few expect a similar supply rebound in 2024. That means if inflation is to continue falling, a slowdown in demand may be necessary. This could be especially true in the services sector, where prices tend to be more closely linked to wages – and where wage growth has remained relatively strong due to demand for workers.

Financial markets could also complicate the Fed's job. Stock and bond markets rebounded late last year, which could effectively negate some of the Fed's efforts as investors would feel richer and companies could borrow more cheaply. That could help the economy in the short term, but force the Fed to act more aggressively, increasing the risk of a recession down the road.

“If we don't keep financial conditions tight enough, there is a risk that inflation will pick up again and reverse the progress we have made,” Lorie K. Logan, the president of the Federal Reserve Bank of Dallas, warned this month . in a speech at an annual conference for economists in San Antonio. As a result, the Fed should leave open the possibility of another rate hike, she said.

3. The unwanted surprise

The economy had some lucky moments last year. The weak Chinese recovery helped keep commodity prices in check, contributing to the slowdown in US inflation. Congress avoided a government shutdown and resolved the debt ceiling impasse with relatively little drama. The outbreak of war in the Middle East had only a modest effect on global oil prices.

There is no guarantee that the good fortune will continue into 2024. The growing war in the Middle East is disrupting shipping lanes in the Red Sea. Congress will face another government funding deadline in March after passing an emergency bill on Thursday. And new threats could emerge: a deadlier coronavirus, conflict in the Taiwan Strait, a crisis in a previously obscure corner of the financial system.

Either of these possibilities could disrupt the equilibrium the Fed is trying to achieve by causing a spike in inflation or a collapse in demand – or both at the same time.

“That's what keeps you up at night if you're a central banker,” said Karen Dynan, a Harvard economist and former Treasury Department official.

While such risks always exist, the Fed has little room for error. The economy has slowed significantly, leaving less cushion in case growth is further affected. But with inflation still high — and memories of high inflation still fresh — the Fed may struggle to ignore even a temporary price spike.

“There is room for a mistake on both sides that would ultimately lead to job losses,” Ms. Dynan said. “The risks are certainly more balanced than a year ago, but I don't think this gives decision makers that much more comfort.”

Audio produced by Patricia Sulbarán.