Is Jerome Powell’s Fed experiencing a soft landing?

The Federal Reserve appears to be moving closer to an outcome its own economists thought unlikely just six months ago: returning inflation to normal levels without plunging the economy into recession.

A lot can still go wrong. But inflation has fallen significantly in recent months: it stands at 3.1 percent annually, down from a peak of 9.1 percent in 2022. At the same time, growth is solid, consumers are spending and employers continue to hire people contract.

That combination is a surprise to economists. Many had predicted that a red-hot labor market would cool down with far more vacancies than available workers would be painful process. Instead, workers returned from the sidelines of the labor market to fill open spots, helping with a relatively painless rebalancing. At the same time, healing supply chains have helped increase supplies and reduce shortages. Goods prices are no longer driving up inflation, but have even started to pull it down.

The Fed hopes for “a continuation of what we have seen, namely that the labor market becomes more balanced without a significant increase in unemployment, that inflation declines without a significant increase in unemployment, and that growth moderates without a significant increase of unemployment. Federal Reserve Chairman Jerome H. Powell said Wednesday.

As Fed policymakers look ahead to 2024, they are firmly aiming for a soft landing: officials are trying to estimate how long they need to keep interest rates high to ensure inflation is fully under control without unnecessarily hurting economic growth to bring to a standstill. That maneuver is likely to be a delicate one, which is why Mr. Powell has been careful not to declare victory prematurely.

But policymakers see this clearly coming into focus, based on their economic projections. The Fed chairman indicated Wednesday that interest rates are unlikely to rise to 5.5 percent from 5.25 percent unless inflation shows a surprise rebound, and central bankers forecast three rate cuts by the end of 2024 as inflation continues cool down and unemployment increases only slightly.

If they can pull off that landing, Mr. Powell and his colleagues will have made a huge achievement in the U.S. central banking system. Fed officials have historically pushed the economy into recession as they tried to cool inflation from the levels it reached in 2022. And after several years in which Mr. Powell faced criticism Because he failed to anticipate how permanent and severe inflation would become, such a success would likely shape his legacy.

“The Fed is looking pretty good right now, if you look at the developments,” said Michael Gapen, head of U.S. economics at Bank of America.

Respondents in a regular survey of market participants by the research firm MacroPolicy Perspectives are more optimistic about the chances of a soft landing than ever before, with 74 percent saying a recession was not needed to return inflation to the Fed’s target in December. 1-7 survey, up from a low of 41 percent in September 2022.

Fed employees started to anticipate a recession after several banks blew up early this year, but stopped predicting one in July.

People were gloomy about the prospects for a soft landing, partly because they thought the Fed had reacted too late to rapid inflation. Mr. Powell and his colleagues argued in 2021 that higher prices were likely to be “transitory,” even as some prominent macroeconomists warned that this could last.

The Fed was forced to change course dramatically because these warnings proved prescient: inflation has now been above 2 percent for 33 months in a row.

When central bankers started raising rates in response, they did so quickly, pushing them from near zero in early 2022 to their current range of 5.25 to 5.5 percent in July this year. Many economists feared that slowing the economy so abruptly would cause whiplash in the form of a recession.

But the temporary call looks a little better now – it just took a long time for “temporary” to play out.

Much of the reason inflation has subsided stems from the recovery of supply chains, the elimination of shortages in key goods like cars, and a return to something more akin to pre-pandemic spending trends, with households buying a range of goods and services rather than just stay-at-home splurges like couches and exercise equipment.

In short, the pandemic problems that the Fed expected would prove temporary have disappeared. It just took years instead of months.

“As a charter member of the interim team, it took a lot longer than many of us thought,” said Richard Clarida, the former Fed vice chairman who served until early 2022. But, he noted, things have adjusted.

The Fed’s policies have played a role in cooling demand and keeping consumers from adjusting their expectations for future inflation. “So the Fed deserves some credit” for that delay.

While higher interest rates haven’t cured supply chains or convinced consumers to stop buying so many sweatpants, they have helped cool the market for major purchases like homes and cars somewhat. Without those higher borrowing costs, the economy might have grown even more, giving companies the means to raise prices more dramatically.

The question now is whether inflation will continue to cool even as the economy continues to hum along at robust levels, or whether a more pronounced economic slowdown will be needed to push it back the rest of the way. Based on new forecasts, the Fed itself expects growth to slow substantially next year, from 2.6 percent this year to 1.4 percent.

“They certainly did very well, and better than I expected,” said William English, a former senior Fed economist and now a professor at Yale. “The question remains: Will inflation return all the way to 2 percent without more slack in labor and goods markets than we have seen so far?”

To date, the labor market shows few signs of rift. Hiring and wage growth have slowed, but unemployment stood at a record low of 3.7 percent in November. Consumers continue to spend and growth in the third quarter was unexpectedly high.

While these are positive developments, they leave open the possibility that the economy will have just a little too much energy to allow inflation to fully cool, especially in key services categories.

“We don’t know how long it will take to make the final move on inflation,” said Karen Dynan, a former chief economist at the Treasury Department who teaches at Harvard.

Against this backdrop, setting policy next year could prove more of an art than a science: as growth cools and inflation falls, a rate cut will be a fairly obvious choice. But what if growth is strong? What if inflation stagnates but growth collapses?

Mr. Powell acknowledged some of that uncertainty this week.

“Inflation continues to fall and the labor market continues to rebalance,” he said. “It’s going so well so far, although we kind of assume it’s going to get harder from here, but so far that’s not the case.”

Mr. Powell, a lawyer by training who spent much of his career in private equity, is not an economist and has sometimes expressed caution about using major economic models and guides too religiously. That lack of commitment to the models could come in handy in the coming year, said Bank of America’s Mr. Gapen.

It could make the Fed chief — and the institution he leads — more flexible as they respond to an economy that has been fiendishly difficult to predict as past experience proves to be a bad precedent in the wake of the pandemic.

“Maybe it was right to let a man who was skeptical of frameworks manage the ship during the Covid period,” Mr Gapen said.