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Monetary Policy, the Soft Landing, and the Economic Outlook From Here

Image via Tagger Yancey

An often-discussed term in macroeconomics, especially in the past year, has been the so-called “soft landing.” Any observers of American politics will note Federal Reserve Chair Jerome Powell’s repeated use of the term to describe what he hopes will happen in the US economy later this year. But what is a soft landing, and why is the Fed working so hard to orchestrate one?

For some background, Congress mandates that the Federal Reserve pursue two main goals: price stability and reasonably full employment. In other words, the Fed desires both low inflation and low unemployment. But achieving both of these at once can be difficult because inflation and unemployment are seen by most economists as inversely related—bringing one down often results in the other increasing.

Now, amid upwards price pressures following the Covid-19 contraction, the Fed is looking to bring inflation back down to its 2 percent target. But its tool for doing this—raising the federal funds rate, which discourages investment and slows the economy—is precisely what tends to cost jobs and push the unemployment rate up. If the Fed overshoots even a little bit, tightening monetary policy so much that the economy enters a recession, that’s known as a “hard landing.” The soft landing, in contrast, would see the Fed increase rates just to the level where growth slows enough to bring inflation back down, but not so much that a recession is triggered. It’s a difficult needle to thread, involving just about as much luck as skill, but the Fed has done it once before.

So what are the odds they can pull off another soft landing? Expectations vary, but many economic indicators are positive. The US economy added 517,000 jobs in January 2023, exceeding the Dow Jones estimate by a whopping 330,000. The unemployment rate now sits at 3.4 percent, a 54-year low. Retail sales rose 3 percent in January, more than a full percentage point higher than predicted. This shockingly strong labor market and healthy retail spending point toward a far more resilient economy than many anticipated.

There are also reasons for concern, however. The most recent Consumer Price Index report, which measures inflation on a monthly basis, indicated far less happy news. Seasonally adjusted, annualized supercore inflation—a measure that excludes food, energy, shelter, and used car prices, which tend to be more volatile—rose from 1.8 percent last month to 3.7 percent now. More conventional core inflation, which excludes only food and energy, rose from 3.1 to 4.6 percent. Core Personal Consumption Expenditures (PCE), the Fed’s preferred metric, doesn’t tell a much more positive story, with inflation rates moderating but still remaining above 4 percent. “Most any way you look at it,” according to Jason Furman, a Harvard economist and former chair of President Obama’s Council of Economic Advisors, “inflation is well above three percent.” And it seems highly unlikely to come all the way back down within the year, even if a recession does occur.

The strong jobs report is good for consumers, but it also signals to the Fed that tightening rates hasn’t worked, likely spurring even more restrictive monetary policy. Similarly, the inflation report shows that price increases aren’t coming down, and rate hikes will no doubt continue as a result. The message these numbers send to the Fed is fairly clear: Their work has not yet had the desired effect, meaning rates need to continue increasing and stay high for longer.

But is this the right approach, even with the recession risk? Larry Summers, who has served as Fed chair and director of the National Economic Council, thinks so. He has characterized the tradeoff as one “between short run reductions in unemployment and permanent changes in inflation.” Essentially, recessionary losses in the job market would be temporary, while the price increases brought by continued inflation would be permanent. This makes tackling inflation the obvious priority, while collateral job losses can be recouped later. Additionally, increases in the unemployment rate only directly impact the relatively small group of people that end up losing their jobs. By contrast, inflation impacts everyone across the economy, whether through higher prices and lower real wages or through diminished savings. For both of these reasons, it’s clear that the Fed should, as it is likely to do, stay the current course of raising interest rates in order to get price increases back down, even at the cost of a potential recession.

So with continued rate hikes all but certain, how is the economy likely to react? Investors are interestingly out of sync when it comes to the economy’s future. The bond market, which had previously predicted a decline in interest rates by the end of this year, has now seen an adjustment in expectations, with the two-year Treasury note yield surging in anticipation of rates staying above 5 percent for the rest of the year. Stocks have responded less decisively, however, with investors seemingly split on the prospect of a recession later this year. The lack of an immediate, negative reaction in the stock market speaks to a surprising optimism among investors: A recent Bank of America survey found that only 24 percent of fund managers expect a recession, compared to 77 percent last November. This hopefulness has been buoyed in recent months by strong trends internationally, including China’s reopening and low European gas prices due to an unseasonably warm winter. So while it’s hard to predict exactly what’s in store for the economy, a soft landing is certainly not off the table. The January jobs numbers indicated an economy that has stayed remarkably resilient in the face of a tightening investment landscape, and that may well continue as interest rates climb even higher.The economy has survived several rounds of rate hikes so far with few signs of an impending recession—what’s a few more? To quote Larry Summers again, the soft landing “represent[s] the triumph of hope over experience.” Predicting the future is never easy, but investors’ best bet today is to continue hoping, even with further rate hikes all but guaranteed, that the economy really will land softly.