How the Fed Can Engineer a Soft Landing in the Economy
(Bloomberg Opinion) -- Despite President Donald Trump criticisms that the Federal Reserve has raised interest rates too far, too fast, thereby penalizing the economy, the flatness of the bond market’s yield curve suggests policy rates are just about at a level that neither stimulates nor restrains growth. But in order for the Fed to engineer a soft landing from last year’s heady growth rate, policy makers must act nimbly as they did in the 1990s to sustain the expansion. Erring in keeping policy rates on the low side will likely encourage financial imbalances, while erring on the high side risks a recession.
There’s no question the economy is slowing, but what constitutes a soft landing? That would be a transition to a slower pace of growth that remains sufficient to hold unemployment relatively constant while inflationary pressures remain at bay. A soft landing for the economy, however, does not necessarily mean a soft landing for investors, as seen in the performance of markets last quarter when concerns of a slowdown grew.
Another feature of a soft landing would be a fairly stable path of short-term interest rates. In an economy that was not too hot or not too cold, we would expect fairly steady monetary policy. That’s the story told by the yield curve, which is now essentially flat out to five-year maturities and only slightly steep thereafter. That suggests bond traders do not anticipate much change to policy rates over the medium term.
Not anticipating much change, however, is not the same as no change. The Fed will need to tweak policy occasionally to keep the expansion on track. Recall what occurred in the 1990s. Between February 1994 and February 1995, the Fed hiked rates 300 basis points to 6 percent. Over the following 12 months, they cut rates by 75 points. In 1997, the central banked edged rates up by 25 basis points, held off from doing anything else for more than a year, and then cut rates a total of 75 basis points to 4.75 percent in response to the Asian financial crisis. The Fed began hiking again in 1999, eventually bringing policy rates to 6.5 percent in mid-2000 before the economy slipped into the 2001 recession.
During most of that time, the yield curve remained fairly flat as one might expect if monetary policy was largely focused on sustaining an expansion rather than responding to or recovering from a recession. The Fed now faces a similar situation.
Still, this means that setting policy becomes harder, not easier. Policy is fairly easy in a recession — the Fed just keeps cutting rates. The initial stage of the reversal of those rate hikes is also straightforward — policy is sufficiently far from neutral that the Fed has room to hike freely. Now, the path forward is not obvious. The Fed may need to tweak policy rates higher or lower as they respond to shocks both positive and negative.
The Fed will need to judge which shocks need a response, the magnitude of the response, and the appropriate timing to reverse the response. Each decision is fraught with challenges that could result in financial instability or recession. Was the Fed’s response to the Asian financial crisis too large and thus set policy rates too low, setting the stage for dot-com bubble? Or was the magnitude correct but not reversed soon enough? Similarly, did the reversal go too far, helping trigger or at least worsen the subsequent recession?
It will take both skill and luck for the Fed to keep the economy on track. On a basic level, I am watching carefully the Fed’s view on inflation. Does the Fed continue to believe that inflationary pressures remain contained? If so, the Fed will likely err on the side of more dovish policy, which would sustain the expansion but at the risk of financial excess.
On the other hand, should the Fed’s fears shift toward inflation, they will be more likely to hold policy too tight for too long, even in the face of negative shocks. I will be watching the yield curve carefully when evaluating these two scenarios. If the yield curve inverts and the Fed keeps hiking rates, I suspect the expansion’s end will be on the horizon.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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