Santa, The Easter Bunny, and the “Soft Landing”
Myths, like dreams, give expression to people’s hopes and fears. The three myths mentioned in the title dwell on the hopes side of the matter. Of course, no one in business and finance believes in Santa or the Easter Bunny, but many still hold to the notion that the Federal Reserve (Fed) can bring inflation under control without precipitating significant economic weakening or a recession. Of course, anything is possible. The Fed may shepherd the economy to a “soft landing” while inflation on some kind of internal momentum glides back within the Fed’s acceptable range of 2 percent a year. Stranger things have happened. But if past experience is any guide, likelihoods suggest that the efforts at monetary restraint taken in the last couple of years will precipitate still more economic cooling, possibly a mild recession, and that any immediate relenting of monetary restraint could set the economy up for another bout of inflation down the road.
The link between successful inflation fights and recessions has haunted markets and the economy since the Fed began its anti-inflation efforts in March 2022. As policy makers began to raise interest rates and otherwise withdraw liquidity from the economy, Chairman Powell referenced this historical tradeoff. While reassuring all of the Fed’s commitment to bring inflation down to an acceptable level, he warned that the effort could precipitate a recession, implying that recession would be a reasonable price to pay to rid the economy of inflationary pressure. Consistent with the Chairman’s comments, in 2022 the Fed officially forecasted a recession in 2023.
Historical Context: Inflation and Recession
In presenting this tradeoff to the public, Powell reflected concerns that had grown out of the nation’s last experience with inflation in the 1970s and early 1980s. That period suffered a succession of failures in which the Fed, under pressure from market participants and the White House, relented prematurely on anti-inflation monetary restraint in order to engineer a soft landing and lost in both efforts. Recession developed anyway as a lagged response to past restraint and the early abandonment of restraint failed to flush out inflationary pressures sufficiently, setting the economy up for another bout of inflation after the recession.
Thus, the Fed began restraint in the late 1960s as inflation picked up, but it then reversed itself in 1970 when signs of economic slowing appeared. The economy fell into recession anyway, albeit a mild one. And because of the Fed’s premature abandonment of its anti-inflation fight, the cyclical recovery saw worse inflation than ever by 1973. The pattern repeated twice more before that decade ended. Only in the early 1980s, when the Paul Volcker Fed held to monetary restraint and accepted recession, did the inflationary pattern break.
The Fed’s 2022 Forecast and Reality Check
Circumstances from one historic period to another always differ, but avoiding such a pattern was no doubt on Chairman Powell’s mind when he offered his perspective in 2022. The Fed’s recession forecast for 2023 was entirely consistent with this perspective. But the economy seemed to luck out in 2023, probably because there was still post-pandemic recovery in the works and the economy had suffered a retrenchment in early 2022. The recession failed to materialize as forecast, and inflation moderated, though by no means did it return to the Fed’s preferred range. This combination of events seems to have led many, including the good Chairman, to believe, past experience to the contrary, that the nation can lick inflation and avoid recession. Monetary policy makers removed recession from their forecasts, and though they resisted the temptation to reverse their anti-inflation policy posture, talked a lot about their plans to do so.
Current Policy Pressures
Now signs of economic slowing have emerged. Because this unfolding reality is likely a delayed response to past monetary restraint, Chairman Powell has come under three sorts of pressure:
First is the continuing desire among monetary policy makers to avoid the mistakes of the past and hold to the Fed’s anti-inflation posture a while longer. Though inflation has moderated considerably from where it was two years ago, at under 3.0 percent over the past year, it remains well above the Fed’s desired target rate.
The second pressure comes from the financial community and the media. Confident that inflation is on the wane and that notwithstanding the lagged effects of past monetary restraint, the Fed can avoid recession if it relents on its anti-inflation efforts immediately, if not sooner, they have pressured for just such a policy reversal.
Third is pressure from the White House. The unusual nature of the campaign to date has distracted politicians, but the administration will almost certainly push for monetary ease as the election nears and do so without regard to longer-term considerations.
Looking Ahead: The Likelihood of a Soft Landing
Powell seems to be ready to comply with these second two pressures. At the July meeting of the Economics Club of Washington, he assured his audience that inflation will abate as a lagged response to past restraint and that it would be a mistake to wait for full victory on this front before changing policy. Then at the annual meetings in Jackson Hole, Wyoming, he said the time had come to change policy. Implicitly he is making an assessment on the economy somewhat in contradiction to the one he is making on inflation. On inflation, he is counting on lagged effects of past restraint to reach his goal. In contrast, he implies that, on the economy, a quick change now can erase any lagged effects of restraint, avoid recessionary pressures, and produce a soft landing. He might pull it off, but the somewhat contradictory nature of his argument, not to mention the mistakes of the past suggest that the prospect is dubious. What is more likely is something near recession or a mild one, and a re-emergence of at least some inflation pressure at a future date.
