Rate Hikes Usually Cause Recessions. Here’s Why the Fed Could Stick a Soft Landing.

- Advertisement -


Spiraling inflation and an aggressive monetary policy tightening cycle by the Federal Reserve could be enough to tip the US economy into a recession even in the best of times. Add an Eastern European war into the mix, and the risk of a downturn spikes.

- Advertisement -

A proverbial soft landing may not be as far-fetched as these dynamics would make it seem, however. While the reasons for concern are plenty—an oil price shock, severe geopolitical risk and a flattening yield curve, among others—the US economy remains fundamentally strong. Consumers are flush and businesses are in hiring mode. And many economists and Fed officials contend that could be enough for it to withstand both a series of interest rate increases and fallout from a war—or make a recession relatively mild.

- Advertisement -

At the center of the debate over whether it’s time to prepare for a recession is the Fed and its indication that it plans to raise interest rates at least six more times this year in an attempt to slow down rising inflation—and officials have recently hinted they could move faster than that. Steep rate-hike cycles have historically been catalysts for economic downturns, because moving aggressively to slow the economy carries an inherent risk of going too far, stalling growth and driving up unemployment.

Indeed, major economic forecasters see a roughly 1 in 3 chance of a recession within the next 12 to 18 months, not-insignificant odds that have more or less doubled since Russia invaded Ukraine in late February.

- Advertisement -

“Prior to the invasion, when we were just talking about policy normalization at the Fed, I was thoroughly convinced the economy could absorb what the Fed was planning to do,” says RSM chief economist Joe Brusuelas. While that’s still a possibility, he adds, “what I’m uncertain about is the external shock that has little to do with economic or financial fundamentals, and everything to do with geopolitics.”

Alan Blinder, a former Fed economist and current Princeton University professor who has a forthcoming book on monetary and fiscal policy history over the past 60 years, says the Fed has just once in the last 11 tightening periods nailed a “perfect soft landing,” which came in the early 1990s. But twice more, in the mid-1960s and early 1980s, the central bank raised interest rates without sparking an official recession—and such “soft-ish” landings, he said in a recent presentationare not all that rare.

Still, eight recessions out of 11 tightening cycles is not a stellar track record, and some economists say the risk now is significant in part because the Fed waited so long to act on inflation—consumer prices have risen 7.9% year over year, and are expected to keep climbing—that it has to tighten quickly in order to get things under control. That in turn could carry a greater chance of overdoing it.

Related Reading

“This is the biggest disconnect, historically, between current Fed policy and their goals of price stability,” says Stephen Roach, a former chief economist at Morgan Stanley now a senior fellow and lecturer at Yale University. “I can’t think of any time when they have been faced with the type of tightening they have to contemplate in the current environment where they’ve been able to sidestep a recession.”

The compounding factor is the Russia-Ukraine war, which could keep oil and other commodity prices elevated for months to come and risks bringing down global demand. A prolonged period of higher oil prices would mean US households are forced to redirect spending from discretionary goods and services to necessities—gas and groceries, primarily—which slows the economy by itself.

At the same time, continued supply chain disruptions stemming from both the war and Covid-related factory shutdowns in China could keep prices elevated even longer. All of which would lessen the chances that the Fed is able to get a handle on inflation soon.

The US remains more insulated from the impact of Russian sanctions than Europe does. But still, “if there’s significant global financial market stress above and beyond what we’re seeing today, if there’s significant deterioration in global economic conditions, it’s hard to see how the US economy fully escapes that,” says Robert Rosener, senior US economist with Morgan Stanley.

Despite the mounting risks facing the US economy at home and abroad, however, there are a number of reasons to believe the economy could grind on even amid a tightening and uncertain environment. The labor market is remarkably strong, with record levels of job openings, sustained demand for workers, a rising labor force participation rate, and unemployment that has fallen to 3.8%, just 0.3 percentage point above its pre-pandemic low.

American consumers remain healthy, too, even as the cost of living rises, and an estimated 60% of households continue to hold on to excess savings built up during the pandemic. At the same time, home and stock portfolio values ​​have soared, and overall household net wealth climbed more than 37% between the first quarter of 2020 and fourth quarter of 2021, Federal Reserve data shows. Growth has been so strong that even a sizeable slowdown this year could still leave the economy humming along.

,I can’t think of any time when they have been faced with the type of tightening they have to contemplate in the current environment where they’ve been able to sidestep a recession.,


— Stephen Roach, former Morgan Stanley chief economist

Take Morgan Stanley’s recent gross-domestic product estimates, for example. Economists with the firm recently adjusted their GDP forecast to reflect higher commodity prices and tighter financial conditions, lowering it to 4% growth for 2022, down from 4.6% at the start of the year. “That’s a good chunk that we’ve taken out of growth to reflect recent developments,” Rosener says. “But you look at that, and it’s hard not to see an economy that has a buffer to absorb some of these things.”

The hope among some economists is that the economy’s underlying strength will be enough to keep any recession relatively shallow and short-lived, if not fend it off entirely. Brusuelas, who sees a roughly 20% chance of recession, expects any slowdown to be of the “garden variety”—nine to 12 months of a household-driven contraction sparked by a decline in consumer purchasing power as commodity prices spike.

Tempering the pain is likely to be the US labor market, where employers who have spent more than a year competing to hire and retain workers are unlikely to let them go amid a mild slowdown or recession, economists say. The layoff rate hit an all-time low of 0.8% in December and climbed only 0.1 percentage point in January despite the Omicron-induced economic shutdowns, government data shows—a possible signal of how employers might react to the next slowdown as well. A delay in widespread layoffs would minimize the hit to employment, thereby limiting the damage to consumer demand and the broader economy.

“Businesses know that their problem is cutting through the business cycle, through the pandemic, through any disruption, is going to be labor and finding qualified workers,” says Mark Zandi, chief economist at Moody’s Analytics. “They’re loath to reduce payrolls.”

Still, while the economy for now looks steady, the level of uncertainty around the world means the status quo could change quite quickly, says Roach, the Yale economist. “We need to be cautious in avoiding overcomplacency,” he says, “based on what we perceive to be a fairly balanced situation today.”

Write to Megan Cassella at [email protected]

,

Credit: www.marketwatch.com /

- Advertisement -

Stay on top - Get the daily news in your inbox

DMCA / Correction Notice

Recent Articles

Related Stories

Stay on top - Get the daily news in your inbox