Business Standard

What soft landing?

- MICHAEL R STRAIN The writer is director of Economic Policy Studies at the American Enterprise Institute ©Project Syndicate, 2024

Many economists and commentato­rs have been popping champagne corks and toasting the US Federal Reserve for having steered the economy toward a soft landing. There’s just one problem: The plane has not landed yet.

What would a soft landing look like? Inflation would remain at or adequately close to the Fed’s 2 per cent target for a sustained period, while employment and economic output would increase at rates low enough not to put upward pressure on prices, but also high enough to avoid recession.

Yes, the US economy has slowed considerab­ly, and with much less economic hardship than many — including me — feared would occur. In 2021, the economy added an average of 604,000 net new payroll jobs each month. In 2023, average net monthly job gains had fallen to 251,000. Likewise, consumer-price inflation has cooled significan­tly. Using the Fed’s preferred measure — the personal consumptio­n expenditur­es (PCE) price index — inflation (on a year-on-year basis) peaked at 7.1 per cent in June 2022 and fell to 2.4 per cent by January 2024.

But despite this impressive progress, the economy remains some distance from a soft landing. The labour market is unsustaina­bly hot. In February, employers added 275,000 jobs — around three times as many as one would expect during a soft landing. Beyond any one month’s data, there are other reasons to be concerned that this underlying trend could accelerate. If that happens, inflation could get stuck at a level inconsiste­nt with the Fed’s target, reducing — perhaps even to zero — the number of times the Fed will cut interest rates this year.

Growth expectatio­ns for 2024 were improving over the course of last year in response to the Fed’s pivot away from hiking interest rates. Financial conditions eased in the fourth quarter of 2023 and are looser than a year ago, which could lead to the economy running hot. The pace of monthly job gains did not decelerate last year. In fact, net employment may have trended higher in the fourth quarter of 2023 and into February 2024, while wage growth has hovered around 4.5 per cent for the past year — well above a level consistent with the Fed’s target for price inflation. The economic outlook is unusually murky, with different sets of indicators telling different stories. Some signs point to the economy being on the verge of cooling rather than running hot. But those indicators also suggest that a hard landing — a recession — is more likely than a soft landing.

For example, new orders of capital goods have slowed to a crawl, which suggests a dim outlook for business investment and overall gross domestic product (GDP) growth. Moreover, other factors are increasing concerns about the outlook for consumer spending. In January, retail sales fell sharply, down 0.8 per cent relative to the previous month, while forecaster­s expected only a 0.1 per cent drop. Credit-card delinquenc­ies have been rising for all age groups since early 2022, and recently surpassed pre-pandemic levels.

Most importantl­y, consumer sentiment remains in recessiona­ry territory, likely owing to high price levels and high interest rates. Sentiment is important, because recessions are ultimately caused by a loss of confidence in the future. Consumers who are worried about their near-term finances limit their spending. A recessiona­ry psychology takes hold, which leads businesses to cancel vacancies and lay off workers, which in turn further reduces demand.

A soft landing — inflation durably at the Fed’s target and employment and GDP growing at a sustainabl­e pace — is less likely than the economy reaccelera­ting or mildly contractin­g. And if a recessiona­ry mindset takes hold, the economy may contract rapidly, because no business wants to be the last to take a conservati­ve posture on spending and headcount. When the unemployme­nt rate rises by half a percent within one year, it continues to rise into recessiona­ry territory (it is often said to go up in an elevator but come down on an escalator).

Of course, a soft landing is not impossible. The most compelling argument for this outcome is that tightness in the labour market has been driven largely by elevated levels of job vacancies, not by excessive employment. Job openings were 75 per cent higher in March 2022 than in February 2020, but they are currently less than one-third higher than pre-pandemic levels. If high interest rates can lower vacancies without destroying jobs, then the Fed might achieve a soft landing.

The Fed must peer through the murk and assess which direction the economy is heading. At the time of this writing, investors in the bond market expect the first rate cut to occur in June. With the Fed’s policy rate well above the so-called “neutral rate,” this is a reasonable forecast. But if the economy is as strong this spring as it was at the start of this year, the balance of risks will point away from rate cuts. In other words, keep your champagne corked.

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