Did the Fed pull it off? Are we experiencing the “soft landing” that we’ve been hearing about? Is this the mid-90s again, where Alan Greenspan was leading the charge to a soft landing?
Many have heard or read about a soft landing in the news, but some may not have an actual definition of what it means. One definition, according to a speech delivered by Tom Barkin, the President of the Federal Reserve Bank of Richmond, is “where inflation completes its journey back to normal levels while the economy stays healthy”. One might then wonder 1) what are normal inflation levels and 2) what defines a healthy economy.
First, we’ll define normal inflation. As part of the Fed’s price stability mandate, they would define normal inflation as 2% (measured by Headline Personal Consumption Expenditure, or Headline PCE). Stable prices would generally be viewed as an environment of low and stable inflation. The 2% number is somewhat arbitrary, but the Federal Open Market Committee (FOMC), or “the Fed”, made it the official target in January 2012. Defining Barkin’s second point of a healthy economy would point towards the Fed’s other mandate: maximum employment. The Federal Reserve Bank of San Francisco described maximum employment as an environment where “anyone who wants a job can get one”.
Generally speaking maximum employment is considered when the unemployment rate is around 4%. As my colleague Syl Michelin pointed out in the first paragraph of this Walkner Condon 2024 outlook, we are sitting at 3.1% inflation and 3.7% unemployment. Using the flight of an airplane as a metaphor, the soft landing (no recession) occurs when there is little turbulence upon the plane landing (inflation back to normal). Mission (nearly) accomplished, right?
After periods of inflation and the corresponding federal funds rate increases, soft landings aren’t as easy as they seem. Alan Blinder, a Princeton economist and former Fed vice chair, examined soft and hard landings between 1965 and 2022. During the period there were 11 periods of rate increases and Blinder identifies five “soft” or “softish” landings (see figure below). Note that Blinder defines the “softish” landing as no recession for at least a year after a Fed tightening cycle. Earlier in this outlook, Syl describes a “hard landing” when the central bank raises interest rates so aggressively that it crushes the economy enough to kill inflation. In other words, a recession following monetary tightening.
Many look to the 90s for the “perfect” soft landing. However, a major difference between Greenspan’s soft landing following the mid-90s hiking cycle is that the Fed proactively raised rates since the real federal funds rate was around zero, and the FOMC anticipated inflationary pressures. The current rate hiking cycle was very reactionary: The inflation spike that started in 2021 was the highest we’ve seen in nearly four decades and the Fed responded by raising rates in 2022.
Let’s look to the 1972-1974 cycle, which resulted in a hard landing. Headline inflation rose from 3.8% to 11.5% during this period. With the federal funds rate rising over 9.6%, among other factors, the economy crashed. In February of 1974, the Fed lowered the federal funds rate from its peak of 10.8% to 9%. This move by the Arthur Burns-led Fed surely wasn’t declaring victory on the battle with inflation (it was still around 10%!), but it can show the danger of cutting rates prematurely. Inflation continued to soar and the result was the Fed raising rates (again) just months later.
Let’s explore two of the rate hike cycles in the 80s, when Back to the Future was released. Leading up to 1985, the year the movie hit theaters, there was a small but consistent tightening starting in 1983. This rate hike cycle wasn’t a reaction to a rapidly-increasing inflationary environment or even an attempt to get ahead of inflation based on economic indicators; the economy was experiencing disinflation at the time. The Fed’s response was really an effort to normalize the federal funds rate after a recession. The rate hike cycle of 1988-1989 increased rates just over 3%. Then Iraq invaded Kuwait, oil skyrocketed, and a hard landing was in full force.
The interesting thing about all of these different periods of rate hikes and landings is the element of luck: What were the conditions outside of the Fed’s control that may have caused a recession? War, the Great Financial Crisis, a pandemic, etc. There are plenty of parallels between the tightening cycles discussed but they all have their own unique fingerprints, as well. For example in the case of the 1972-1974 cycle they were experiencing massive food and oil price increases due to supply shocks. The inflation that started in 2021 experienced similar shocks, but to a lesser degree. The amount of uncontrollable variables and unexpected world events make the Fed’s job very difficult.
The Fed is currently in a wait-and-see mode. Rate hiking is paused for the time being to see more economic data released in 2024. They don’t want to declare victory quite yet. More pain could come if inflation comes roaring back, whether it were caused by policy mis-management or external, uncontrollable factors. For the time being, however, a soft landing doesn’t appear to be out of the question.