Soft Landing Less Likely Than in 1990s

Summary

• A soft landing appears less likely now than in the mid-1990s as:

1. This time the output gap is positive against negative in the 1990s.
2. The Federal Reserve (Fed) was much more proactive in the 1990s.
3. The Fed has tightened more but policy transmission has been weaker this time.
4. Deglobalization, worker power, and fiscal policy support disinflation less this time.

• So far, positive supply shocks including an immigration surge have supported the soft landing.
• These positive shocks are over, and the Fed may no longer escape the traditional inflation/unemployment trade off.

Market Implications

• I still expect the Fed to cut twice in 2024 in line with market pricing 1.9 cuts, down from 2.7 cuts before Friday’s non-farm payrolls (NFP).
• Long term, the Fed may have to revise its easing plans, though this revision would be unlikely before the 5 November US election.

Soft Landing More Elusive Now Than During 1990s

The Fed tightening and easing cycle of 1994-5 is often described as ‘the perfect soft landing’ (Chart 1). In this note, I argue a soft landing could be more difficult to achieve this time.

First, this time the starting point is less favourable than in the 1990s (Chart 2). When the Fed started easing in July 1995, the US output gap was -0.6% of potential GDP (Congressional Budget Office estimate) and unemployment was 30bp above its long-term value. By contrast, this time the output gap is +1% of potential GDP and unemployment is 30bp below its long-term value.

This difference reflects that the Fed was more proactive in the 1990s.

Fed More Proactive in the 1990s

Second, the Fed was more concerned over inflation during the 1990s. It hiked in February 1998, even though there was no inflation acceleration. In the minutes. the Fed explained:

• The policy rate was low at 3% and close to zero in real terms. This was partly aimed at allowing households, businesses, and lenders to rebuild their balance sheets following the savings and loans crisis of the 1980s.
• With balance sheets now repaired, risk existed that the low interest rate could lead to demand expanding faster than supply.

The Fed added, ‘The history of past cyclical upswings had demonstrated the inflationary consequences and adverse effects on economic activity of delayed anti-inflation policy actions.’ The memory of the 1980s when inflation got out of control and the Fed had to engineer a deep recession was still fresh.

Contrasting, this time the Fed did not start hiking until March 2022, when core PCE was already above 5.6% YoY, up from below 2% in 2019. This delayed reaction reflects three main factors. First since the late 1990s, US inflation had struggled to rise to 2%, which the Fed saw as a policy issue.

In May 2003, the FOMC statement said ‘the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.’ This was followed by a speech from then Governor Bernanke who explained very low inflation can be harmful (e.g., when private balance sheets are weak, when it makes the zero lower bound constraint on policy easing more likely to be binding, or if it risks triggering a downward wage price feedback loop).

Eventually, the Fed decided to take action and in August 2020 announced the adoption of Flexible Inflation Targeting (FAIT). Under this new framework, ‘following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.’ The framework likely encouraged the Fed to be ‘patient.’

Second, the inflation surge was viewed largely as supply driven and the pre-pandemic reining policy orthodoxy was to look through supply shocks on the assumption they would prove temporary.

Third, the monetary policy pandemic response had been extraordinarily large and took time to turnaround. During the GFC, the Fed balance sheet expanded by the equivalent of 19ppt of GDP over six years (Chart 3). During the pandemic, the Fed balance sheet expanded by the equivalent of 16ppt of GDP over two years! The Fed felt it could not start raising the Federal Funds Rate (FFR) until it finished buying securities and although it started tapering its purchases in November 2021, these did not end until March 2022.

The Fed tried offsetting its slow start this time with a more intense tightening campaign, but this still fell short.

Weaker Transmission This Time

Third, policy transmission has been weaker this time. The Fed tried offsetting its slow start with faster tightening. It hiked the policy rate 525bp over 17 months or 31bp/month, against 300bp over 17 months or 18bp/month in 1994-95. Policy, measured by the spread between the actual and the Taylor rule FFR, is tighter this time (Chart 4).

However, the transmission of monetary tightening appears to have been weaker this time. Interest rate sensitive expenditures, namely residential investment and durable goods, initially fell more this time but recovered well before the Fed started easing.

This recovery is remarkable given the strong growth in residential investment and durables consumption caused by the extreme policy easing in 2020-21. This could reflect that, with the US economy coming out of decades of low inflation and interest rates, households and businesses had termed out their debt at low interest rates.

Also, the rapid policy tightening led to financial instability and bank failures in the spring of 2023. As a result, the Fed has extended implicit guarantees to all depositors. These could have encouraged risk taking on the part of depositors and banks, and weakened the transmission of policy tightening, as the very high delinquency rates on credit cards shows.

Furthermore, financial conditions (FCIs) tightened less this time than in 1994 (Chart 6, I used the Fed FCIs where the value of the index is the weighted impact of the components on GDP the following year). This could reflect stronger expectations of a Fed put in a post-QE world (the ‘Greenspan put’ came to life with the 1998 FFR cuts).

Macro Backdrop Less Favourable to Disinflation

Fourth, the macro backdrop is less favourable to disinflation than in the 1990s. The US was globalizing in the 1990s, signing NAFTA in 1992. The impact can be seen in the decline in goods price inflation through the 1990s and eventual deflation (Chart 7). By contrast, this time goods prices are already deflating.

In addition, the 1990s saw workers’ bargaining power decline with industrial action declining (Chart 8). This resulted in low wage growth and supported disinflation. Contrasting, this time risk exists that workers could fight for a higher income share, which would be inflationary.

Lastly, the 1990s were an era of fiscal consolidation (Chart 9). By contrast, since 2022 fiscal consolidation has stopped and risk exists that an already large fiscal deficit could widen further.

Luck Running Out, More Good Policy Needed

This somewhat gloomy review begs the question of how the Fed managed to bring inflation down to about 2.5% from a peak of 5.5%. I think through a combination of good policy and good luck. Fed tightening has helped disinflation through restricting demand and guiding down inflation expectations.

Also, the Fed has been lucky in that economic normalization has unwound the pandemic-induced demand and supply imbalances. In addition, the Fed has benefitted from an immigration surge that on balance has helped disinflation through higher labour supply and slower wage growth.

However, the Biden administration has tightened the border, which could explain the slower NFP growth, lower unemployment and faster wage growth. If these trends continue, the Fed may no longer escape the inflation/unemployment trade off and may have to rethink its easing plans, though it is unlikely to do so before the US election.

Market Implications

I still expect the Fed to stick to its 2024 plan for two additional 25bp cuts, likely at the November and December FOMC meetings.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)