In recent conversations about the effort to ease inflation, you may have heard about the various landings—from a “soft landing” to a “hard landing” to “no landing” at all. Whichever way we land, we will likely feel some jostling in the economy.
What does all of this talk of landings mean?
When the Federal Reserve, the U.S. central bank, becomes concerned about inflation, it raises interest rates, which in turn slows the pace of economic growth. If the central bank raises interest rates too much, it may cause a recession—also known as a hard landing.
A hard landing is characterized by a pronounced contraction of economic activity, leading to significant negative consequences for employment and overall economic health. Highly volatile food and energy inflation will often spike, and lending standards will often tighten. Overall, Fed action will prove to be “too restrictive,” which leads to a recession.
However, if the central bank can raise interest rates just enough to slow the economy and reduce inflation without causing a recession, it has achieved what is known as a soft landing. In this scenario, instead of a sharp downturn, the economy experiences a gradual and controlled slowdown, punctuated by easing inflation, slowing labor markets, and slightly tightened lending standards in response to Fed action.
A soft landing is the Fed’s goal when it seeks to raise interest rates just enough to stop an economy from overheating and experiencing high inflation. Soft landing may also refer to a gradual, relatively painless slowdown in a particular industry or economic sector.
Most experts agree that the Fed has managed to achieve only one soft landing in the past 60 years: in the 1994-95 fiscal year, after Fed officials pivoted quickly to cutting rates. Back then, inflation was around 2% and Fed officials were lifting rates to prevent it from rising. Today, with inflation above 3%, Fed officials are trying to force it down.
As for a no landing, that is essentially postponing either a hard or soft landing to sometime in the undefinable future. The possibility of a “no landing” scenario for the US economy is a hotly debated topic, as the Fed moves to reduce inflation with several rounds of interest rate hikes.
Simply put, the primary objective of the Fed is to tame inflation. A no landing is marked by economic growth that’s too strong to allow inflation to fall all the way to 2%, where the Fed aims for it to be, and therefore an economy that will need more Fed rate hikes. It is possible that elevated interest rates eventually land the U.S. economy into a recession.
It’s Not Easy
Once the economy is operating with little or no slack, anything that boosts demand could stoke inflation. Meanwhile, anything that lowers demand could send the unemployment rate rising, a process that is hard to stop once it starts.
Getting monetary policy just right is not easy. While higher interest rates are necessary to bring inflation under control, it is difficult to assess precisely how much tightening is needed to achieve it or when the rate hikes should stop.
With the economy continuing to operate above its long-term potential, the Fed might have to increase rates further. However, an increase in rates also increases the risk of uncontrolled fallout. If the labor market slows down, coinciding with households depleting their pandemic-era savings, and potentially a resumption of student-debt payments, consumers might decrease their spending more than anticipated, pushing the economy into a recession.
Higher interest rates also create stress in the business and financial sectors. An increase in company bankruptcies caused by higher financing costs might also lead to an economic downturn spinning out of control.
The extended supply chain dislocations, crippling inflation, and 16 months of Fed policy tightening have all contributed to an atmosphere of heightened theorizing about a potential landing.
What Could Go Wrong?
The Fed Stays Too Tight
If the Fed holds rates too high for too long, it will risk an unnecessarily severe downturn. The 1994-95 soft landing occurred after Fed officials pivoted quickly to cutting rates. After doubling their benchmark federal-funds rate to 6% over 12 months through February 1995, they realized they might have acted too aggressively. Growth faltered and global forces appeared to be tamping down price pressures. They reduced rates three times starting in July.
The Economy Stays Too Hot
The Fed lifts rates to fight inflation by slowing economic activity. That occurs, partly, as higher borrowing costs and lower asset prices lead executives to spend and hire less. But the economy has proven surprisingly resilient so far to the Fed’s aggressive moves, offering fewer signs that companies are taking such steps. Consumer spending and business activity are showing signs of accelerating again after slowing last year. If that continues, Fed officials could conclude that inflation’s decline risks stalling out unless they raise rates higher, increasing the chances of a recession.
Energy Prices Take Off
Rising oil prices threaten to drive inflation higher while reducing growth by slowing discretionary spending. This could lead to stagflation—simultaneous slow growth, high unemployment, and rising prices. Such a shock is the opposite of what’s desired when trying to engineer a soft landing. Rising diesel, jet, and marine fuel prices could reverse recent declines in inflation, which were driven by lower transportation costs, and instead push up prices on everything from food to construction.
Fears and Expectations
In past episodes, the Fed hasn’t raised rates when facing a one-time supply hit that lifts prices. But because inflation has been high for 2½ years, officials have reason to fear a new price shock would spur inflation. The economy could be hit by some market crackup or geopolitical crisis. Officials say consumers’ and businesses’ expectations of future inflation play a critical role in determining actual inflation. Higher gasoline prices threaten to drive up those expectations, which have been remarkably stable.
While the war between Israel and Hamas currently remains far afield from where the majority of oil production takes place in the Middle East, the potential implications of this conflict escalating and spilling over to other countries such as Iran puts a potential floor in place for the price of oil in the near-term, while also adding a degree of upside risk that was not present before this new tragic war broke out.
So far, the U.S. economy has proved exceptional among its peers in how smoothly the disinflation process has proceeded. At the same time, Europe remains economically stagnant, and China is struggling to resolve issues in its overinvested and deeply indebted property sector. Those problems weaken consumer confidence and spending and threaten to spill over into the financial sector.
Since the U.S. is not an isolated island, weaknesses in these foreign markets might soon find their way to the domestic economy, either through lower demand for American exports or through a fall in earnings of multinational companies. Any sudden developments in these foreign markets, such as a hypothetical wave of bankruptcies and financial turmoil in China, might result in a global economic downturn, from which the U.S. would not be immune.
Many analysts see the rapid adjustment in global borrowing costs and the lagging effects of past increases as a source of instability. Most experts acknowledge that it is difficult to identify and measure geopolitical effects because isolating these effects from other potential factors is difficult. Geopolitical events will always increase market volatility. However, the market is not a good predictor of the outcome.
Conclusion: We Will Land Sometime, Some Way
The Fed has made it clear that they will focus on bringing down inflation and that interest rates will remain high for a long period of time. If inflation rises, the odds of recession will increase as the Fed will have to raise rates further.
In any case, going forward, the real growth is expected to be on the lower side. The geopolitical situation is expected to be volatile and crude oil prices are likely to rise further. The U.S. has already drawn down its strategic oil reserves, and high oil prices may see the resurgence of inflation . Moreover, U.S. fiscal deficit spending is also quite high.
How long does it take to know whether the U.S. economy will have a soft or hard landing during periods of monetary tightening? Conventional wisdom used to say it would take 18 months to two years for interest rate changes to affect the economy. Since the pandemic, things have changed and it’s hard to say if that’s the case anymore. Also, it’s difficult to say how long it will take to figure out what kind of landing we might see.
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