Is the US economy headed for a soft landing?

Jeffrey Frankel July 18, 2023 09:53

A skydiver leaps out of an airplane and discovers that his parachute will not open. On his way down, he encounters a hang glider who asks him how he is doing. The free-falling man shouts back, “Okay, so far!”

For many, the US economy these days bears a striking resemblance to the parachutist. Ever since March 2022, when the Federal Reserve began to hike interest rates and shrink its balance sheet, the consensus among economists has been that the United States is headed toward a hard landing. Many economists have been confidently forecasting a recession for over a year, with some even asserting that the economy has already started to contract.

The inverted yield curve in bond markets suggests that the financial sector has also been bracing for a recession. In fact, the term “recession” has appeared more prominently in news media over the past year than is typically the case during an actual downturn. This view has clearly resonated with the general public, with a May 2022 poll finding that 55% of Americans believed that the US was already in a recession, compared to 21% who disagreed.

But all these predictions have been far off the mark. The US economy did not enter a recession in 2022, nor is it necessarily headed for one in 2023 or 2024. Similarly, the global economy has avoided a contraction.

To be sure, aggressive monetary tightening is often followed by a slump. But that does not mean that a hard landing is inevitable. After all, if the Fed were to pull off a soft landing, would it not resemble our current situation? Perhaps our metaphorical parachute has already deployed, and what we are witnessing is the US economy’s gradual, controlled descent.

What constitutes a “soft landing” remains open. As several critics have argued, the Fed is unlikely to achieve its goal of bringing down inflation to 2% by 2024 without causing a sharp increase in unemployment and drop in GDP.

But a soft landing might best be defined as a gradual slowdown of output growth and employment to levels below their potential and natural rates, accompanied by a decline in inflation. To qualify as soft, this economic slowdown must not develop into anything more severe than a very mild recession. But inflation need not reach 2% immediately. While US employment and output have indeed slowed in 2022, this is relative to 2021, when the economy recovered rapidly from the previous year’s recession. Despite the monetary tightening, GDP growth has averaged 1.8% over the past four quarters.

Surprisingly, recent data indicate that the US labor market has remained exceptionally strong. Over the first half of this year, job growth averaged 278,000 per month. This, too, is often labeled a “slowdown,” and it is – but only when compared to 2022. Given that the average monthly increase in employment since 2001 has been 87,000 and that total monthly population growth is roughly 100,000, the current rate of job growth is rapid by any relevant standard. Moreover, the unemployment rate remained steady at 3.6% in June, nearly matching the low levels of the late 1960s. The current job market is anything but recessionary.

There is also good news on the inflation front. The June Consumer Price Index (CPI), released last week, showed a 12-month inflation rate of 3%. This represents a significant decline from June 2022, when the inflation rate peaked at 9.1%.

Falling rental costs suggest that CPI inflation will likely continue to decline in the coming months. To be sure, some of the decline in headline inflation since 2022 can be attributed to volatile food and energy prices, which were also among the main drivers of the preceding inflationary surge. But even when food and energy are excluded, 12-month core CPI inflation was 4.8% in June, down from 6.3% in October 2022. Personal consumption expenditures inflation – the Fed’s preferred measure – was at 3.8% in May, down from its June 2022 peak of 7%.

A severe recession might have enabled the Fed to achieve its stated goal of bringing down inflation to 2% this year. But if avoiding the social costs of a serious contraction means stabilizing inflation at 3-4%, with 2% as a longer-term goal, that seems like a worthwhile tradeoff. Such an outcome should be considered a soft landing.

Of course, there is a sense in which a recession is inevitable. Every economic expansion must end at some point. But, contrary to popular belief, there was no reason to declare a slump in 2022, nor is there reason to predict one this year or even in 2024. The probability of a recession is roughly 15% in any given year. Even though the chances of a recession are much higher now, owing to the Fed’s rapid interest-rate hikes, I would still put the likelihood of one happening in the next 12 months at less than 50%.

Like the proverbial skydiver, the US economy jumped out of a plane more than a year ago. It is currently being buoyed by an unusually powerful updraft, preventing a rapid descent. Despite the confidence with which many predict a recession, the parachute might still deploy as planned, allowing the economy to achieve a soft landing after all.

Copyright: Project Syndicate

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Jeffrey Frankel

Professor of Capital Formation and Growth at Harvard University