Fed Seeks Economic Soft Landing, Rarely Seen in Wild: QuickTake

(Bloomberg) -- In many ways, the U.S. economy couldn’t look much better. Unemployment is at rock-bottom levels and wages are finally rising. Inflation is contained, holding near the Federal Reserve’s 2 percent target. So why are financial markets jittery? One reason is investors are worried that the central bank could mess things up. The Fed has been steadily raising interest rates to bring growth down to a more sustainable pace without flipping the economy into a recession. It’s an ideal that economists call “a soft landing.” Achieving this much-desired and often elusive condition can be more art than science.

1. What’s a soft landing?

In short, it describes the Fed’s main job these days: Slow the economy enough to prevent overheating and financial excesses, but not so much as to trigger a contraction in gross domestic product. Doing that takes a combination of smart policy making and luck. Mark Zandi, chief economist of Moody’s Analytics Inc., likens it to “landing in the fog on an aircraft carrier that’s in the middle of choppy seas.”

2. Has the Fed ever accomplished this?

Fed Seeks Economic Soft Landing, Rarely Seen in Wild: QuickTake

Yes, but only once, in 1994-1995, under then-Chairman Alan Greenspan. The central bank back then doubled interest rates to 6 percent and succeeded in slowing economic growth without killing it off. The tighter credit did have adverse consequences, though. It led to huge losses for bond market investors and contributed to the 1994 bankruptcy of Orange County, California. Mexico was also compelled to seek a bailout from the U.S. and the International Monetary Fund.

Fed Seeks Economic Soft Landing, Rarely Seen in Wild: QuickTake
Fed Seeks Economic Soft Landing, Rarely Seen in Wild: QuickTake

3. Can the Fed do it again?

Theoretically, yes. But it’s even more difficult now than in 1994. That’s because unemployment back then was still elevated and the job market wasn’t as tight as it is now. Today’s unemployment rate, 3.9 percent as of December, is already below what many economists say is its long-run sustainable rate. So achieving a soft landing today would mean not only slowing growth but nudging up unemployment. The trouble, as former New York Fed President William Dudley has noted, is that the economy historically “has always ended up in a full-blown recession” whenever joblessness has risen by more than 0.3 percentage point.

4. Why doesn’t the Fed just leave well enough alone?

Some economists favor this path, arguing that central bankers in the past have overreacted to inflation signs, depriving workers of the wage gains they’d make in a tight labor market. On the other hand, underlying inflation has risen and is near the Fed’s target. The worry is that, as companies find it increasingly difficult to find workers, they’ll aggressively bid up wages, which would lead to sharply higher consumer prices as companies seek to protect profits. It’s that sort of damaging wage-price spiral that the Fed is trying to avoid.

5. Is that the Fed’s only concern?

No. Some officials also worry that low interest rates risk pumping up asset prices to levels that will prove unsustainable. That’s what happened in the middle of the last decade when housing prices were bid up way too far -- with disastrous results. This time the concern has focused on stocks and bonds, especially risky corporate bonds. Some of that disquiet has dissipated recently as those markets have sold off.

6. So what’s the Fed’s strategy?

Fed Seeks Economic Soft Landing, Rarely Seen in Wild: QuickTake

Edge interest rates up just enough to keep asset prices from rising too high and the unemployment rate from falling too low. Policy makers increased rates four times in 2018 and provisionally penciled in two more for 2019 when they met in December. That plan has since been called into question by turbulence in the financial markets. Fed Chairman Jerome Powell raised the possibility of a pause in the Fed’s rate-hiking campaign in response to the downside risks that investors perceive to the economy.

The Reference Shelf

  • Bloomberg QuickTake explainer on why measuring inflation is such tricky business and one on the Fed unwinding its balance sheet.
  • A 1995 research paper by economist Edward Yardeni says economic busts often are the result of central bank policy-engineering to correct failures in managing booms.
  • Former Fed Chairman Alan Greenspan recounts his 2000 soft-landing miss in his book, "Age of Turbulence."
  • The International Monetary Fund’s guide to how central banks tame inflation through inflation targeting.

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