Fed may have missed chance on inflation
Economic ‘soft landing’ likely difficult to attain
Among the best known of Wall Street yarns is the one about economic expansions rarely dying on their own accord, but rather falling victim to an inflation-hunting Federal Reserve.
The historical record lends credence to that view.
Each of the 10 recessions since 1955 was preceded by a significant rise in benchmark interest rates, incremental nudges of the monetary needle intended to produce a moderation of inflation without pushing the economy over the cliff.
Economists call that favorable outcome a “soft landing,” a term derived from the space race of the 1960s.
In the post-war era, there have been only two such landings, in 1984 and 1994 — and their rarity is understandable. Mark Zandi, chief economist at Moody's Analytics, likened its execution to “landing in the fog on an aircraft carrier that's in the middle of choppy seas.”
With the global pandemic still raging, the economic seas aren't just choppy, they are heaving. And the economic air isn't just foggy, it's pea-soup thick.
Tough love
The possibility that the Fed will need to aggressively raise interest rates and take other measures to contain inflation has emerged as perhaps the biggest risk to the economy and asset prices in the new year. Monetary policy works on a lag of nine to 12 months, making it difficult to know if rates have risen too far until it's too late.
In fact, the Fed began cutting rates shortly before seven of the most recent 10 recessions, but to no avail. At other times, policymakers were willing to accept an economic downturn as an acceptable (if regrettable) price for getting inflation under control.
The clearest example of that tough love policy was in the early 1980s, when Fed Chair Paul Volcker engineered two recessions — the second of which remains among the most severe in U.S. history — to reign in double-digit inflation.
But Volcker subsequently executed the first soft landing, in the mid-1980s, twice jacking up short-term rates without crashing the economy. (Those higher rates drove up the value of the U.S. dollar, however, creating a different set of problems.) The only other soft landing was in 1994, when the Alan Greenspan-led Fed doubled its benchmark lending rate amid rising inflation but stopped just in time to prevent a downturn.
Yet even that favorable outcome came at a steep price: The sharp rise in yields caused massive losses for bondholders, contributed to Orange County California declaring bankruptcy and triggered Mexico's so-called Peso Crisis.
“People don't realize that we cannot forecast the future,” Greenspan once acknowledged. “What we can do is have probabilities of what causes what, but that's as far as we go.”
That wasn't far enough in the late 1990s when Greenspan — concerned about “irrational exuberance” in the stock market — failed to refill the monetary punch bowl in time to avert a recession following the bursting of the dotcom bubble.
Uniquely difficult
Whatever policymakers do in coming months, some economists think the Fed already has made a critical mistake by failing to foresee pandemic-related changes to the labor market and global supply chains, thus putting monetary policy well behind the inflationary curve.
Historically, the best predictor of an economic hard landing is the relationship between the U.S. Treasury's twoyear and 10-year note. When the twoyear yield rises above the 10-year yield — a configuration known as a negative yield curve — a recession usually begins within a year.
In each of the two soft landings since the 1950s, the Fed moved to cut shortterm rates shortly after the curve inverted.
Currently, the yield on the two-year note is still about three-quarters of a percentage point below the 10-year, though the gap narrowed significantly after Fed chair Jerome Powell's hawkish pivot on inflation last month.
Engineering an economic soft landing will be especially problematic this year because it is impossible to know if the omicron variant will cause inflation to rise still higher by further impairing global supply chains, or reduce inflation by limiting demand, or some mind-boggling combination of both. And unlike most previous attempts to orchestrate a cyclical slowdown, the Fed now has another monetary level to monitor, having added a significant presence in the U.S. bond market following the Great Recession in 2009.
Even if Powell & Co. ultimately sticks the landing, the final approach seems certain to be bumpy. Buckle up.