Citi sings high on US stocks and the US economy, is the "soft landing" destiny gear starting to turn?

According to the Zhitong Finance and Economics APP, Citigroup has raised its year-end target level for the S&P 500 index by 15% because it now believes that there is a greater possibility of a soft landing for the US economy and that returns will also increase. The bank predicts that the S&P 500 index will reach 4,600 points by the end of 2023. The outlook for 2024 seems even brighter, with Citigroup predicting that the index will rise from the previously forecasted 4,400 points to 5,000 points. Citigroup currently expects earnings per share for S&P 500 index constituent companies in 2023 to be $220, higher than the previous estimate of $215.

Citigroup has also pushed back its prediction of a possible US economic recession from the fourth quarter of this year to the first half of 2024. The bank's strategist says that the new S&P 500 index forecast better reflects this. Despite recent economic data showing resilience in the US economy, the path to a soft landing for the Federal Reserve remains narrow.

The Federal Reserve "walks a tightrope"

Throughout the process of curbing inflation, policymakers at the Federal Reserve have been focused on raising the benchmark overnight interest rate to a sufficiently high level and achieving this goal at a fast enough pace to prevent the public from losing confidence. The reality of seeking a "soft landing" is also relatively ideal: inflation decreases without an economic recession or significant unemployment. However, the second half of this process - when and at what pace to cut interest rates to ease the pressure on households and businesses - will be equally important, and perhaps even more difficult to grasp.

In the three economic recessions in the United States prior to the COVID-19 pandemic (1990-1991, 2001, and 2007-2009), the Federal Reserve had raised interest rates to high levels and began lowering borrowing costs 3 to 13 months before the start of the economic downturn. This indicates both how difficult it is to prevent a downturn once the economy starts to decline and how challenging it is to match the slow effects of monetary policy with the desired effects the economy may need in the coming months.

Antulio Bomfim, Global Macro Head of the Global Fixed Income Team at asset management firm Northern Trust and former special advisor to the Federal Reserve Board, said that allowing high inflation to take root in the economy is a grave sin for central banks. Federal Reserve officials would still prefer to make the mistake of excessive tightening, going too far in ensuring that inflation is under control, rather than abruptly stopping and risking a rebound in inflation.

Bomfim said, "We all hope that the slowdown in the economy is 'just right.' But there is still a considerable margin for error... What you see now is an economy that is resilient in terms of economic activity but also stubborn in terms of potential inflation... The risk of doing too little - this asymmetry - still exists."

Due to the stickiness of core inflation, according to the Federal Reserve's dot plot, this could mean that the Federal Reserve will raise interest rates at least once more, although investors are betting that the Federal Reserve has finished raising rates, and the interest rate futures market reflects a probability of no more than one in four of the Federal Reserve raising rates again. Last week, the Federal Reserve raised its policy rate to a range of 5.25%-5.50%, marking the 11th rate hike out of the past 12 meetings.

Is the "puzzle" of low inflation coming together?

Recent data on wages, economic growth, and prices have put Federal Reserve policymakers in a dilemma as they consider whether to further raise borrowing costs and how long to keep interest rates high. In the year of the 2024 US presidential election, this discussion could determine the overall direction of the economy - whether it will grow or shrink, whether the unemployment rate will rise or the job market will remain strong.

After 16 months of rapid monetary tightening, the annualized growth rate of the US economy in the second quarter still exceeded expectations, reaching 2.4%, higher than the level considered non-inflationary. This momentum is expected to continue into this quarter. Over the 12 months ending in June, wages increased by 4.5%, falling back from the peak during the pandemic period but still higher than the Fed's target inflation rate of 2%.

Although the overall inflation rate in the United States has fallen significantly from its peak in 2022, indicators measuring potential price pressures have changed more slowly. The core personal consumption expenditures (PCE) price index, which excludes food and energy costs, remained close to 4.6% for several months before slowing to 4.1% year-on-year in June, still more than double the 2% target.

Federal Reserve Chairman Powell said last week that the pieces of the puzzle of low inflation may be coming together, but he is not convinced. Powell said, "We need to see inflation come down and core inflation remain high. We believe we need to stay focused on the task. We believe we need to keep policy at a restrictive level for some time. We need to be prepared to raise rates further."

Powell acknowledged that delicate adjustments are needed to restrain inflation without overly restricting economic activity and to keep interest rates low ahead of any economic downturn caused by declining inflation and weakening economic activity.

Powell said, "You would stop raising rates before inflation reaches 2%, and you would start cutting rates when inflation reaches 2%." The Fed's policy rate affects the economy by changing the fees that lending institutions charge consumers for credit cards, auto loans, and mortgages, as well as the fees that businesses pay for bonds or credit lines.

Rate-cut guidance

Powell did not provide direct guidance on how the Fed will assess when it is appropriate to lower rates, saying, "When we feel it's appropriate to lower rates, we'll feel it's appropriate to lower rates." However, he believes that inflation will not return to target levels until the economy slows below potential levels for a period of time, which will directly affect the number of jobs.

Things have been moving in this direction. Although the unemployment rate remains low, the rate of worker resignations has decreased, job vacancies have decreased, and wage growth has slowed, indicating a cooling of the job market from the pandemic year characterized by labor shortages and significant wage growth. However, as the inflation rate recedes from its peak without causing any significant employment disruptions, some economists question whether Powell - who focuses on the need for economic "slack" to achieve the task of reducing inflation - is making the same mistake as his predecessors in laying the groundwork for an unnecessary deep recession.

Lindsay Owens, Executive Director of the labor-focused economic policy organization Foundations Collaborative, pointed out, "Exploring how low unemployment and low inflation can coordinate should be the 'North Star'... It's a broad frontier for us to try. The discussion of the timing of interest rate cuts may be around October."

Although the latest policy maker projections released by the Fed in June show that rates will decline by the end of 2024, the decline is smaller than the expected decline in inflation, meaning that inflation-adjusted rates are actually still rising.

The risk of continuing restrictive policies is that the economy will not only slow down but also collapse, and former Fed officials know that this situation could happen quickly. According to the minutes of the Federal Open Market Committee (FOMC) meeting in December 2000, Fed staff and policymakers worked to address weak data and concluded that the economy would slow down but not contract. However, a month later, the Fed began cutting rates, ultimately determining that the recession began in March 2001.

Thomas Simons, Senior U.S. Economist at Jefferies, said, "I think the economy is in the 'eleventh hour' phase, with bank lending slowing, credit costs rising, and loan default rates increasing, consistent with the situation at the start of every recession since 1980. Given that inflation remains tricky, they will eventually let rates go too high or keep them at this level for too long. The pace of their rate cuts will be relatively slow because they need this weakening inflation to develop."