The “soft landing” question

With inflation on the slide and the economy supporting a strong labor market, has the Fed achieved the ideal outcome?

Let’s begin by reviewing a story we know all too well: back in March 2022, with the Fed’s target policy rate still near zero, headline CPI indicated that prices were 8.5% higher than the year before. This elevated level of price growth proved to be a call to action for the Fed, whose legal mandate makes price stability its official responsibility. Policymakers deemed that intervention was necessary to beat back inflation.

That month, the Fed moved to increase interest rates from historic lows, beginning what would become a streak of 10 consecutive interest rate hikes in the span of just over one year before pausing in its last meeting with its target policy rate around 5%. The Fed’s intervention throughout this time has been informed by a traditional model of monetary policy—raise interest rates to tighten financial conditions and slow economic activity which will allow inflation to cool.

While interest rates are the primary monetary policy tool used by the Fed to control the pace of the economy, there are some problems with using them to do so. Milton Friedman, winner of the Nobel Prize in economics, famously pointed out that using interest rates to implement monetary policy has “long and variable” effects. A key problem lies in the point about variability—to what extent will higher interest rates actually impact the economy? The reality is, it’s nearly impossible to know in real time.

Consequently, the Fed has been dealing with two-sided risks. On one side is the risk of the Fed’s actions not being firm enough which could result in persistent inflationary pressures. On the other side is the risk of being overly forceful, potentially triggering a recession and widespread job losses amidst economic decline. And since the effects are often variable, it’s been hard to know if the Fed’s been getting it right.

An ideal outcome has been possible all along: higher rates slow economic activity just enough to reduce inflation without sending the economy into a recession. This is known as a “soft landing”. But achieving a soft landing entails a remarkable balancing act that—given the variability of monetary policy combined with the dynamic nature of the economic environment as policy gets carried out—is akin to walking a high-wire with a blindfold on.

Nine months ago, after the Fed’s fifth consecutive rate hike, talks of a soft landing were widely dismissed as a pipe dream. A survey of economists conducted by the Wall Street Journal placed the odds of a recession occurring within 12 months at 63% in October 2022, up from just 16% the year before. The consensus seemed to be that the Fed was erring on the side of beating back inflation so hard that the economy would fall into a downturn.

Then three months ago, as inflation continued to fall amid the Fed’s ongoing rate hikes, GDP for the first quarter of 2023 was reported to have grown at an annual rate of 1.1%—not a glowing report, but far from the recession that most have been predicting. One month later Q1 GDP was revised up to 1.3%, and one month after that it was revised to 2.0%. The clearer the data became as time went by, the more apparent it was that the economy had been growing faster than most had believed.

With the Fed tapering its interest rate increases by taking a pause at its last meeting, inflation continuing its downward trend toward the Fed’s 2% target, and the economy growing at a pace that continues to support a historically strong job market, the idea of a soft landing is being considered more seriously. The financial news this week has been filled with articles by leading voices in finance and economics suggesting that a soft landing is possible. While uncertainty remains, the flow of economic data seems to suggest the range of possibilities is narrowing and optimism is growing.

The truth is, it’s unlikely anyone will really know we’re headed toward a recession before it actually happens. And it’s just as unlikely anyone will truly realize a soft landing has been achieved before it actually occurs.

Soft landing, recession, or otherwise, investors right now are wise to look beyond the short-term and remind themselves of their investment goals in the context of long-term growth patterns and the future potential of capital markets. Time and again, sticking to an investment plan and committing to markets has been the best way to weather the dynamic changes in our economy.