The so-called “Soft Landing” term that gets bantered about whenever there is some Federal Reserve monetary policy activity refers to bringing inflation down without harming economic growth. It can be visualized as landing an airplane safely with shifting winds all around it. It’s difficult to land an airplane under those circumstances, but it’s nearly impossible to safely land the economy out of inflation’s swirling winds without causing a recession. However, it appears more and more that the Federal Reserve is going to do just exactly that. Here’s what’s working for and against the Fed in this endeavor.
Difficulty of Guiding into a Soft Landing: To create a soft landing for the economy, like the airplane, the right levers and controls must be adjusted and by the right amount. This will cause the economy (again like the airplane) to slow down first before landing. The Fed’s major tool is interest rates—raise the rates and the economy slows down. Raise them too high, and the economy slows down too fast and may crash into a recession. But not raising them high enough won’t bring the economy down enough to restrict inflation. Owing to the sudden, unexpected start of inflation, the Fed was forced to raise rates rapidly in the early going in 2022. Because of this, businessmen, investors, and stock traders have all pointed to the increased probability of a recession, since raising rates rapidly puts the most drag on the economy. In June of this year, the median forecast of a pool of economists showed a 65% chance of a recession in the ensuing twelve months.
Bad Technical Signs Point to Headwinds: The most prevalent technical sign pointing to trouble is what’s known as the inverted yield curve. If you looked at a graph showing bond yields with percentage yields on the X axis and maturity dates on the Y axis you would see in ordinary times that the composite yield for fixed securities (bonds, notes, etc.) would show a steady rise as time moved out into the future. This is owing to the investors requirement to be paid more interest for those bonds that mature well into the future. Then what would it mean if the higher yields occurred in the near term and not the long term thereby creating an inverted curving line? It would mean that bond investors expect that central banks will have to cut rates in the near term to prevent the economy from sliding into a recession. They shun the short term in favor of the long term thereby driving the price of short-term bonds down and the yields up. This phenomenon has been highly accurate in predicting recessions in the U.S. economy over the last fifty years. Another closely watched technical sign is the consumer sentiment survey conducted by the University of Michigan. Consumption is the most important sector of the U.S. economy during normal growth periods, and a pullback by consumer spending owing to inflation and the high interest rates fighting it, could serve to cripple the chances for a soft landing.
Uncommon Bedfellows: In spite of headwinds to the economy, the labor market has been surprisingly resilient. Even with the rapid onset of inflation, the U.S. unemployment rate resides at 3.6%, or almost a fifty-year low. With thirty consecutive months of new jobs being added, the labor market is close to its pre-covid levels. This comes at a time when inflation hit double digits (June, 2022) and has begun to recede, but is not yet down to the Fed’s 2% target. For an economy to have receding inflation and a solid labor market is practically unheard of. Since low unemployment can lead to rising wages it would be inflationary unto itself. Wages and pay rates have risen since the start of the current inflation, but even with the labor market so tight, wage and pay rates have begun to level off. It makes for uncommon bedfellows, but it may prove to be the key to the Fed’s soft landing.
Shifting Data Could Be Misleading: The recent pandemic threw much of conventional economic wisdom for a loop. The red warning lights of recession began flashing for many months since then, but it’s possible that the conventionally built economic models may have overstated the threat of recession. They are designed to predict problems owing to abrupt shifts in data, and could have overstated the threat of a recession as the shifting data more recently is reflecting a return to normal. The yield curve itself could also be misleading. The shift in preference for investors to the longer-term bonds may be based upon the concept that inflation is on the wane, and interest rates may be reduced in the not-far-reaching future to more of an equilibrium. Lower overall interest rates would make the long-term bonds, that still pay higher rates, more popular and more likely to rise in value.
Residual Savings from Covid Lockdowns: During the pandemic many consumers cut back on spending for a variety of reasons. This created a surprise uplift to the amount of household excess savings. The San Francisco Federal Reserve estimates that there still remains in the economy excess household savings of about $500 billion. Adding to that is rising incomes in real terms to households owing to nominal wage and salary growth surpassing the declining rate of inflation. This pent-up demand has been released into the economy gradually, but much of it is still available to fuel a consumer-lead rebound to the economy as inflation slows down.
Conclusions: The name of the game for the Federal Reserve is to whack inflation with higher interest rates (done), and then ease back on the throttle as inflation slows back down to its target level of about 2%. Done properly, it just might avert stifling a growing economy and provide the proverbial, but elusive, soft landing. Even if it doesn’t work out exactly as hoped, the Fed should still be complimented on its efforts to keep the covid economic recovery still moving along without any serious damage being done in spite of inflation.
Sources: The Economist, Turning a Corner, July 22, 2023.