Galloping inflation and 75 basis points increase all but eliminate the possibility of a soft landing.
The unenviable task of curbing the current inflation, the highest in decades, without sending the US economy into a recession became more difficult. Recently, Federal Reserves chair Jerome Powell suggested that a soft landing for the US economy was possible, albeit difficult. However, the latest 75 basis point (BPS) interest rate hike means the chances of achieving a gentle economic turnaround are slim.
Historical Precedents of a Soft Landing
The soft landing analogy is a layman’s way of explaining how the Federal Reserve intends to slow down the economy without tipping it into recession. The aggressive nature of the Fed’s interest rate hike has sent alarm bells ringing over the possibility of a recession.
History shows that a soft landing amidst high inflations and aggressive interest rate hikes is challenging. University of Chicago economist Austan Goolsbee revealed to reporters that a total of thirteen or fourteen recessions had occurred since the second world war. Of the lot, almost two-thirds were caused by interest rate hikes by the Feds. He said,
“Well, it’s definitely a risk. Prices are up so much that the Federal Reserve is getting close to feeling like they have no other choice but to raise rates a lot to try to cool down the economy. And if they do that – you know, we’ve had 13 or 14 recessions since World War II, and more than two-thirds of those recessions were caused by the Fed raising the interest rate faster than the economy can handle.”
Despite the difficulty, there is cause for optimism. In the 1990s, the Federal Reserve engineered the perfect soft landing. It increased its benchmark interest rate from 3% to 6% between late 1994 and early 1995. While the economy slowed down, the Gross domestic product(GDP) never shrunk, and the labor market remained robust with unemployment rates shrinking.
Coincidentally, Alan Blinder, the deputy chair of the Feds in the ’90s who oversaw the soft landing, is optimistic about the current chances. Contrary to popular opinion, he said a gentle landing was not as rare as perceived. Citing historical data, he revealed eleven periods existed between 1965 and 2020 when the Feds hiked interest rates.
According to him, while a soft landing only occurred once, the economic effects were minimal in the other six cycles, with little to no GDP decrease. However, the final five periods saw severe recessions following interest rate hikes. However, Blinder contends that the central bank wasn’t even attempting a soft landing on three occasions.
Despite his optimism, Blinder agrees that the Feds would require luck alongside skill to navigate the current situation and achieve a soft landing. This comes after the Consumer Price Index for June beat the general market expectation resulting in the recent 75 bps hike by the Federal Reserve.
External Factors Likely to Prevent a Soft Landing
External factors make preventing a recession while curbing the inflation rate more challenging. Powell revealed that the pandemic, alongside the Russia-Ukraine conflict currently in its fifth month, had narrowed the pathways for a soft landing.
His sentiments were echoed by the European Central Bank’s (ECB) President Christine Lagarde. She reiterated that Europe felt the high impact of energy shock given its proximity to the conflict and reliance on Russian oil and gas.
Unfortunately, both the ECB and the Feds failed to flag inflation when it started a year ago. They assumed that price increases were the short-term effect of supply chain hiccups and a quickly recovering economy. That failure has seen both bodies struggle to raise interest rates to tame the situation, with the ECB hiking rates by 50 BPS.
Another factor that could further impact the Fed’s envisaged economic soft landing is the job market. The US labor market has remained hot despite the previous rate hikes, with unemployment at 3.6%. This currently works in favor of the Federal Reserve, which expects a slight increase due to its hawkish stance.
Powell has reiterated that there is no way the Feds can reign in inflation without hurting the job market. He said he would consider it a soft landing if the cost of curbing inflation is an 0.5% increase in unemployment.
“We don’t seek to put people out of work. But we also think that you really cannot have the kind of labor market we want without price stability.”
Nonetheless, the chances of a soft landing appear even remote. However, with no interest rate increase planned for August, the economy may have time to cushion the effects of the Fed’s hawkish stance. But only time will tell if enough has been done to ensure a gentle landing. If not, we may be in for a bumpy ride.