Optimism about the economy has grown recently. This is an overdue shift in sentiment given the strengths of the U.S. economy that persisted all of last year when doomsayers called the recession prematurely. A so-called soft landing is arguably playing out.
While that sounds like an unalloyed good, for firms the reality of a soft landing is more complicated. The flip side of falling inflation is waning pricing power, falling margins, and dimmed profits — which companies have to navigate while they’re digesting still-contorted demand patterns, strained labor markets, higher interest rates, and slower growth. To navigate and remain resilient, executives will have to do more than knee-jerk defensive cost-cutting.
The mythical soft landing no longer looks like a myth.
In the middle of 2022, the U.S. economy was overheated, and inflation was reaching new heights. Monetary policymakers responded by aggressively raising interest rates, increasing the risk of a policy-induced recession. To avoid one, the labor market, where much of the pressure was concentrated, had to ease without driving up the unemployment rate — the ultimate arbiter of recession.
That was deemed near-impossible by many, or “at odds with both economic theory and the empirical evidence” as former Treasury Secretary Larry Summers put it in June 2022.
Yet, seven months later, this is exactly what has happened. The pressure has eased, as seen in lower job openings and slower wage growth at the same time as a falling unemployment rate. As far as soft landings go, it’s fair to say we’re in the first stage of one.
From here, the bigger question is will it continue? We expect that the drivers that have allowed the easing in the face of strong job creation will continue to deliver in 2023. On the demand side, labor hoarding has eased as layoffs picked up from exceptionally low levels, and the speed of hiring slowed as employers filled much of their backlog. On the supply side, immigration returned as the pandemic restraints faded and, as wage growth remains strong and savings wear off, labor participation rates may continue to improve.
For a complete soft landing, interest rates must reset.
Even if 2023 squeaks by without recession, a sustained soft landing is a higher bar. Remember that recession risk was centered on aggressively higher interest rates, designed to bring down inflation but which also choke economic activity. To exit a high recession risk, interest rates will need to drop back towards neutral levels, where it’s neither a restraint on activity nor an accelerant, which is unlikely to happen in 2023.
What’s stopping monetary policy from falling towards neutral this year? So far, though inflation has turned into rapid disinflation, its quality isn’t good enough. We’ve seen falling prices in energy and durable goods, while inflation in the service economy has stayed high. To see convincing disinflation in the service economy, wage growth will have to continue to moderate.
But aren’t parts of the economy already in recession?
In the goods-producing part of the economy we increasingly hear weak performance blamed on recessionary conditions. But this merits a closer look. Yes, real goods consumption is falling and has been for the better part of two years – a dip that is historically associated with recession.
The fact remains, however, that the consumption of goods is still well above pre-Covid levels, and above the pre-Covid trend, even after adjusting for inflation. The declining demand in the goods economy reflects the weird contortions of the pandemic, where consumption collapsed, then massively overshot, and then began to fall back from elevated levels. It’s that last phase that drives the recessionary sentiment, even as the level of demand is the highest on record.
Yet aggregates are deceptive, and the pandemic’s aftermath has thrown demand patterns into disarray. For some industries, such as toys, the overshoot proves sticky and demand continues to grow. Others, such as clothing, kept the elevated demand level but have paid for it with no growth. For others, such as furniture, the overshoot is still fading away, and for still others, such as breakfast cereal, the overshoot reversed — and then some.
Interpreting these unusual patterns in real demand and their durability is difficult, if essential, for managers. Even so, these challenges can’t be pinned on a failed soft landing in the macroeconomy.
Meanwhile, the (much bigger) services economy never overshot and instead continues to normalize to pre-Covid trend, with a delay. Spending on hotels, for example, continues to grow even after adjusting for inflation. Here, too, executives must decipher how much longer strong tailwinds can persist and whether a full normalization will be achieved.
Why navigating a soft landing will prove difficult for firms
Though a soft landing sounds enticing, firms feel that everything is getting harder, due to a number of factors:
1. The pandemic delivered firms a moment of unusual pricing power, which is now ending.
In normal times, firms face a trade-off between increasing prices and losing market share. But the pandemic delivered excess demand at the same time as everyone struggled with supply chains. The result was the suspension of the traditional trade-off — companies could raise prices without worrying about losing market share. The macroeconomic expression of this anomaly was inflation. The microeconomic expression was high margins and strong profits.
But as the distortions ease, demand for goods has normalized. Inventories have restocked (and overstocked in some cases). In aggregate, price growth is coming down. For firms, it means margins compress and profits are under pressure.
This is most clearly visible in categories, such as durable goods, where inflation spiked as demand did and supply sputtered. Durable goods inflation is near zero now (and negative for many items). It is also visible for firms across the economy, particularly in retail, where pricing power came and went – and with it margin expansion and profit growth.
Slowly but surely the competitive dynamics of the pre-Covid economy are reasserting themselves, and those that had weak pricing power before — from autos to furniture — are discovering weak pricing power has returned.
While the service economy did not see a demand whiplash, it did experience supply-side challenges with labor availability and costs. These costs were able to be passed on as the recovery took hold, driving higher margins and profits. But as demand slows, the service economy’s moment of pricing power is likely to fade as well — and with it the peak of margins and profitability.
2. The labor market remains tight.
The flip side of a soft landing is a continued tight labor market. It remains hard to hire and it will be more expensive. In the short run, wage growth is likely to fall less than inflation, meaning that wages will pressure margins. And in the longer run, wages are likely to remain elevated because tight labor markets will deliver real wage gains. Firms will need to figure out how to pay for those wage gains when passing on the cost risks losing market share.
3. Capital remains expensive with high interest rates.
Additionally, capital is likely to remain more expensive as interest rates are higher. In the short run, this is driven by policy rates that are well above their neutral level as central banks intentionally try to slow down the economy. And though the Fed will eventually ease, interest rates may stay higher than they used to be. That is because inflation frequently was too low in the years before the pandemic.
What should executives do?
The pressures on firms are the consequences of a strong macroeconomy, not a weak one. Unusual context requires more calibrated thinking. Though controlling cost is never a bad idea, the usual recession playbook of retreating and cutting to fight another day is not well suited for the challenges of a strong economy.
Executives must first ask the following questions to understand the challenges that aren’t a product of cyclical macro trends and won’t be answered by a soft landing:
- Is demand changing because of a slowing economy or because pandemic overshoot in demand is unwinding?
- Which changes in consumer demand and behavior are pandemic distortions, and which are sticky?
- How quickly are their industry’s competitive pricing dynamics returning?
- How can we codify and institutionalize learnings from the pandemic on how to remain resilient for uncertain and shifting conditions ahead?
Then, it’s worth addressing the challenges that a soft landing is likely to continue to bring:
- How can we hire and manage labor costs in a continued tight labor market, but avoid overpaying as a soft landing will bring slowing wage growth?
- Where can we invest in technology to reduce labor intensity and increase productivity?
- How can we build strategic investment plans that incorporate higher interest rates?
- How can we respond to market pressures to focus on short-term performance without sacrificing the innovation and investment required to navigate and exploit technological and social change? [Note: This is a theme we will be exploring in an article in the upcoming May/June issue of the HBR magazine.]
A soft landing remains a deceptively positive outlook for firms. Avoiding a recession is desirable, but the macroeconomic tailwinds to margins and profits are turning into headwinds. Executives must now redouble their efforts to protect and grow both while keeping an eye on the risk of recession that has not disappeared.
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February 17, 2023 at 08:10PM
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