The once-dormant belief that the Federal Reserve can tame inflation without decimating the U.S. economy is gaining new traction.

Inflation is now months beyond its peak and falling, and the labor market has proven to be exceptionally resilient, while business and consumer spending have yet to be significantly hit. This seemed largely unthinkable just a year ago, when the Fed ended its pandemic era of near-zero rates with its first of a series of rate hikes and most economists felt a recession was a near certainty. The debate had focused on just how severe it would be.

With the Fed expected to boost its benchmark federal funds rate above 5% for the first time since 2007, the odds of a so-called soft landing have improved, broadening the possibility that central bankers might be able to force inflation lower without triggering a severe downturn.

"As long as inflation expectations, in the long run, look like they're well-anchored, I think the Fed can afford to be patient" and keep raising rates without the sudden need to pull back to avoid a recession, said Joel Prakken, chief U.S. economist at S&P Global Market Intelligence.

Soft landing vs. hard landing

Under the current view of a soft landing, the Fed's ongoing push to cool the economy through higher rates would be met with a lengthy period where GDP grows below-trend but does not decline; unemployment increases but does not spike; and inflation continues to creep downward.

In a hard landing scenario, a slowdown in hiring is replaced by widespread layoffs, households are unable to pay bills, spending is broadly pulled back, and credit delinquencies and business defaults rise steeply, leading to even more layoffs and a wave of credit stress.

"It would keep spiraling into something worse," said Jeremy Schwartz, senior U.S. economist at Credit Suisse.

Global risks

The risk of a hard landing has set up a steep task not only for the Fed but also for central banks globally, as they try to fight soaring inflation with tighter monetary policy without completely derailing the post-pandemic economy.

"The intention is to bring inflation down," said Kenneth Wattret, head of Europe analysis and insights at Market Intelligence. "The likelihood is they have to hit the economy pretty hard in order to achieve that."

In Europe, the odds of a hard landing vary by location, as some emerging countries are facing double-digit inflation rates and extremely tight labor markets, Wattret said.

Still, one major recession risk, the European energy crisis, was blunted by a mild winter, and many of these central banks are now in a "wait-and-see" mode as inflation begins to dip, Wattret said.

"They're not going to kill Europe's economies to get inflation back to target six months more quickly," Wattret said. "They'll say 'As long as inflation is expected to be back on target in two, three years we've done enough.' And I think we're getting closer to that point."

Recession fears

A lack of clarity around the Fed's policy path forward has stoked recession fears in the U.S.

Fed officials have given little indication of when they will stop raising rates. The central bank could get inflation back to 2% "without a really significant economic decline or a significant increase in unemployment," Chairman Jerome Powell said after the rate-setting Federal Open Market Committee's Feb. 1 meeting.

Still, a particularly tight labor market, with unfilled jobs continuing to outnumber unemployed workers nearly 2-to-1 and unemployment falling to the lowest level in a decade, could force the Fed to push interest rates well above 5%.

A survey of global businesses conducted from late November 2022 through early January by 451 Research found that nearly 60% of respondents believe the economy will worsen over the next 90 days and just 9% think it will improve. More than 33% of the businesses surveyed by 451 Research saw current economic conditions as the greatest threat to sales. Those economic conditions were the biggest macroeconomic threat to these businesses, followed by U.S. inflation and rising U.S. interest rates.

In a January survey, The Conference Board found that a recession or economic downturn was the top concern among U.S. and global CEOs for 2023. A recession ranked sixth on the list of CEO worries a year ago.

The latest CEO survey from EY, released in January, found that 99% of CEOs expected an economic downturn, but many were uncertain of the magnitude. About half said the U.S. recession would be mild.

Slow growth

While a recession may prove to be insignificant or even avoided entirely, the outlook on growth is mixed.

Market Intelligence forecasts U.S. GDP growth to slow to 0.7% in 2023, down from 2.1% in 2022.

The U.S. economy is expected to grow at an annualized rate of 2.1% in the first quarter, according to the Federal Reserve Bank of Atlanta's GDPNow mode. While this is up from the previous estimate of 0.7% growth, it remains below potential.

A Feb. 10 Federal Reserve Bank of Philadelphia report found that forecasters predict the U.S. economy will expand at an annual rate of 0.6% this quarter and 1% in the second quarter. Three months earlier these forecasters believed that the economy would expand just 0.2% in both this quarter and the second quarter.

Widespread expectations of a recession amid improving economic data may be a sign of just how little certainty there is around a global economy attempting to rebound from an unprecedented calamity, said Schwartz with Credit Suisse.

"No one has a lot experience with a cycle like this," Schwartz said.

451 Research is part of S&P Global Market Intelligence.