US Federal Reserve Chairman Jerome Powell
Inflation has returned to haunt the global economy. The fiscal and monetary firepower deployed during the pandemic to prevent a deeper crisis was a powerful elixir for demand, but the real rocket fuel for inflationary forces was the absolute chaos on the supply side of the equation. Companies spent several decades ‘optimising’ supply chains, spreading them thin around the world to reduce costs, which ultimately left them quite vulnerable to shocks. It started with port congestions and chip shortages, before the invasion of Ukraine sent energy and food prices spiralling higher. The draconian lockdowns of Chinese cities in recent months dealt the knockout blow.
Central banks cannot fix supply shocks. Interest rates are the only tool at their disposal and that instrument only affects demand. Even so, with the US labour market having almost returned to full employment and wage growth firing up, the demand side of the economy is overheating too. Policymakers are worried this could lead to a vicious feedback loop between wages and prices that keeps feeding inflation, so they feel compelled to act.
Therefore, the Federal Reserve has embarked on a series of rapid-fire rate increases to combat inflation. Its goal is to cool the US economy without causing significant damage to the labour market or sparking a recession. This soft landing is a very delicate manoeuvre that has only been achieved a handful of times. It requires both skill and good fortune. The question is; can this Fed pull it off?
History is not kind
The finest example of a soft landing in recent history was the 1994–95 experience. Back then, the Fed, led by Alan Greenspan, raised interest rates with brute force and managed to tame inflation while avoiding a recession. However, even this ‘successful’ episode had some unintended consequences, most notably sending Orange County in California into bankruptcy and sparking a currency crisis in neighbouring Mexico.
There are two other examples over the past century when the Fed raised rates without breaking the economy, in 1965 and 1984, yet neither case is very relevant to today. Inflation was running below two percent in 1965, which means very little tightening was needed. Meanwhile in 1984, a crisis was averted because the Fed reversed course and started cutting rates to avoid suffering a third recession in four years. The common characteristic in all three episodes was that the Fed was trying to prevent inflation from moving higher. That’s a completely different situation than now, when it is actively trying to bring it down. The economy is much stronger today and as such, tapping lightly on the brakes probably won’t be enough.
Every other instance has ended with a contraction. The classic pattern is that the Fed tightens until something breaks and drags the economy down with it – whether it is the bond market, the housing market, or the stock market. On the bright side, most of these crises were ‘plain vanilla’ in the sense that the economic downturn was relatively mild and short-lived.
Bond market on alert
With inflation soaring to four-decade highs, markets expect the Fed to raise interest rates to almost three percent by the end of this year and simultaneously shrink its enormous balance sheet, reducing accommodation even further. Since the rate increases have largely been priced in, the tightening process has started and that is already reflected in skyrocketing mortgage rates. This will inevitably slow the economy, both by cooling the scorching-hot housing market and by tightening financial conditions. Whether the impact will be powerful enough to cause a slump cannot be known in advance. That said, the bond market is flashing warning signals.
This soft landing is a very delicate manoeuvre that has only been achieved a handful of times
The most popular indicator that a recession is imminent is when long-term Treasury yields cross below shorter-term ones. This demonstrates that investors are betting on a severe slowdown in economic growth and it has preceded recessions with terrifying accuracy over the past five decades, usually with a lag of several months.
Which measure is the most significant has been the subject of debate among economists for a long time but traders in financial markets generally look at the difference between two and 10-year yields, which inverted earlier this year. Of course, this doesn’t mean a slump is inevitable. Rather, this is the bond market saying that the distribution of outcomes has shifted in this direction.
Swimming in leverage
A downturn may not be inevitable, but it is looking increasingly likely. The surge in inflation is currently outpacing wage growth, eating into people’s real incomes. At some point this negative real wage growth will inevitably hit consumption, which makes up two-thirds of the US economy.
It’s not a local story either. The European and Chinese economies are arguably in even worse shape. Europe has been brought to its knees by its dependence on imported energy, whereas Chinese authorities remain committed to ‘zero Covid’ policies and strict lockdowns that will ultimately kneecap economic growth. If the other two largest economic regions in the world are struggling, it becomes even harder for America to achieve this elusive soft landing.
Leverage is another issue. The total debt across the US economy, both in the public and private sectors, is estimated at almost 380 percent of GDP in 2022. It has been rising steadily for decades. All else being equal, this factor limits how high the Fed can push interest rates before something ‘breaks,’ causing a credit event or something of similar nature. Financial markets are much more fragile nowadays compared to past tightening cycles and are unlikely to be able to withstand significantly higher borrowing costs. Look no further than 2018, when the Fed raised rates to only 2.5 percent and the wheels started coming off the equity market, forcing the central bank to turn around and start cutting rates again a few months later.
Probability of recession
Estimating the probability of recession is guesswork in the best of times, even when done by professionals. The New York Fed has a model that uses the difference between three-month and 10-year Treasury yields as a predictor of a recession over the next year. This model currently implies a very low probability of the economy tanking, less than 10 percent in fact.
However, prominent economists like former Treasury Secretary Larry Summers are not so sanguine. Summers stressed that since 1955, there has never been an instance when inflation was above four percent and the unemployment rate was below five percent that was not followed by a recession within the next two years. The US economy has already overshot both metrics by a mile. This view was echoed by former Fed Vice Chairman Roger Ferguson, who highlighted that a recession “is almost inevitable.” Even Jamie Dimon – the CEO of JPMorgan Chase – pegged the probability of a soft landing at only 33 percent, giving the Fed a slim chance of pulling it off.
The good news
Taking a step back, it’s fruitful to remember that a recession is not necessarily Armageddon. Including the pandemic, there have been 13 of them since the end of World War II, most of them brief and shallow. Many people don’t see it that way because an entire generation has built its perception around what a recession feels like by the decade-long hangover following the 2008 financial crisis. That was an extreme outlier, not the blueprint.
A couple of quarters of slightly negative GDP growth wouldn’t be the end of the world, even though that is the definition of a technical recession. Economic growth in the US already turned negative in the first quarter of the year – does the economy feel like it’s tanking?
Ultimately the focus around a soft landing may be missing the point. The true essence is to avoid a landing where the plane crashes and burns. The US economy is certainly strong enough to handle slightly higher interest rates, although the question is whether the same is true for financial markets. Historically, the Fed has reversed course at the first sign of trouble. Is this time different?