Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared at Project Syndicate.
A skydiver jumps out of an airplane, apparently without a working parachute. On the way down, a passing hang-glider calls out to ask how he is doing. The plummeting man shouts back “Okay, so far!”
For many, the US economy resembles the skydiver. But they are probably wrong.
- Expectations of a hard landing
Many think a hard landing became inevitable when the Fed in March 2022 began a series of interest rate hikes, which totals 5.0 percentage points so far and is expected to continue. Many economists, as well as the public, have been confidently predicting a recession for over a year now, or even saying that it has already begun. In June 2022, 57% of respondents told pollsters that they believed the US was already in recession, versus only 21% who did not. An inverted yield curve in bond markets suggests that the financial sector, too, has been expecting a downturn. The word “recession” appeared far more often in public media during the last year than is usual even in the midst of a true recession.
It is true that, historically, monetary tightening of this magnitude usually leads to recession. But a hard landing is not inevitable. After all, if the Fed were to pull off a soft landing, isn’t this what it would look like? Maybe the parachute will open as intended.
- What qualifies as a soft landing?
How should one define a soft landing? The critics point out that the Fed is unlikely to achieve by 2024 its hope of bringing the inflation rate down to 2 % without the intermediating pain of a sharp rise in unemployment and fall in GDP. But that is too tough a criterion for judging a soft versus hard landing.
A soft landing could be described as a gentle slowdown in the rate of growth of output and employment, enough to bring them below the levels of potential output and the natural rate, respectively, accompanied by a slowdown in the inflation rate. To count as “soft,” the slowdown would have to stop short of a recession, unless perhaps a shallow one. But the inflation rate need not rapidly fall precisely to 2% in order to count as a “landing.”
- The current economy
So far, US employment and output have indeed slowed, but only relative to the breakneck pace of the 2021 recovery from the 2020 recession. Their growth rates have continued to be positive. The rate of GDP growth over the last four quarters has averaged 1.8 %. Surprisingly, the recent numbers indicate that an unusually strong job market persists. Job expansion averaged 278,000 per month over the first 6 months of 2023. This, too, is generally described as “slowing” – which it is, relative to the strong job growth in 2021. But it is still rapid by any meaningful standard. By comparison, total American population growth is about 100,000 per month and expansion in employment since 2001 averaged only 87,000 per month [=(156.2-132.7 million)/270]. So, the current job market is anything but recessionary. Indeed the unemployment rate remained at 3.6% in June, close to the low levels of the late 1960s.
The Fed’s reason for tightening monetary policy was, of course, to bring down inflation, which had become worryingly high in 2021-22. Some progress has been made on that front. The CPI for June 2023, released on July 12, showed 12-month inflation equal to 3.0 %. This is a big decline relative to June 2022, when CPI 12-month inflation peaked at 9.1 per cent. Declining rental costs suggest that CPI inflation will continue to moderate in the coming months. To be sure, some of the decline in headline inflation since 2022 has been due to the volatile food and energy components (just as had been some of the CPI rise on the way up, from 2021 to 2022). But even taking out food and energy, core CPI inflation in June was 4.8 % over the most recent 12 months, down from 6.3 % in the 12 months to October 2022.
Inflation still exceeds the Fed’s long-run target of 2% in PCE terms (that is, Personal Consumption Expenditures inflation, which is the Fed’s preferred measure). It was 3.8% in May on a 12-month basis, having peaked at 7.0 % in June 2022. Presumably, a severe recession might have brought inflation down to 2% this year. But if inflation were to stay at 3-4 % over the coming year, with 2% as a subsequent goal, the tradeoff would be worthwhile to avoid a serious recession.
- A soft landing is possible
Of course, “a recession is coming.” Every economic expansion must come to an end sometime. But, contrary to what one often heard, there was no reason to be confident that it was coming in 2022. Nor has there been any particular reason to predict that it will come this year, or even in 2024. The odds of a recession in any random year are about 15%. The odds over the next 12 months are higher than that, due to monetary tightening – but only something like 40 %, in my view.
Even though the parachutist jumped out of the plane more than a year ago, an unusually strong updraft has kept him at a high altitude for the time being. It is too early to judge that the parachute hasn’t opened as planned. Maybe it will, and the economy will achieve the elusive soft landing.
This post written by Jeffrey Frankel.