Why is it so difficult to achieve a soft economic landing?
Larry Summers is worried that the economy faces a hard landing as the Federal Reserve attempts to bring inflation under control. The former Treasury secretary recently said, “My worst fear would be that the Fed will continue to be suggesting that it can have it all in terms of low inflation, low unemployment and a healthy economy.” Many other pundits also warn that the economy is on the edge of recession. While a recession is not inevitable, history shows that soft landings are difficult to achieve.
Let’s look at some background before getting into the specifics of our situation. During an economic recovery, the unemployment rate gradually declines. A useful definition of a soft landing would be a period of at least three years of economic growth with low inflation even after the labor market has full recovered from recession. Surprisingly, there is no evidence that the United States has ever achieved a soft landing, at least as far back as we have economic data.
In the United States, a recession almost always occurs within two years of the unemployment rate recovering from the previous recession. Instead of leveling off at “full employment,” unemployment almost always begins rising sharply soon after reaching its natural rate.
The closest that the United States has come to a soft landing was 1966-69, when unemployment leveled off in the 3.5 percent to 4 percent range for almost four years. Unfortunately, inflation took off during that period. An extended period of both low unemployment and stable prices seems as elusive as a unicorn.
Oddly, this is not the case in other countries, where soft landings are not particularly unusual. Japan has had extended periods of very low unemployment and low inflation. A notable example of a soft landing occurred in Britain during 2001-08, when unemployment stayed in the 4.7 percent to 5.5 percent range for seven years and inflation remained relatively low. Australia had no official recessions between 1991 and 2020.
In some respects, the challenge facing the Fed is even greater than during the past few business cycles, as for the first time since the 1980s it allowed nominal spending growth for the overall economy to dramatically exceed the rate consistent with its 2 percent inflation target.
Over the past two years, nominal GDP has grown at roughly 13 percent per year. During the first year of recovery from the COVID-19 shutdown, fast growth in nominal spending was justified by the need to recover from a deep slump. But in late 2021, spending began overshooting the previous trend line, causing inflation to rise dramatically.
To get inflation back to the 2 percent target, nominal spending growth must slow to less than 4 percent per year, which would account for the economy’s trend rate of real GDP growth, which has fallen below 2 percent. But if the Fed were to immediately slow spending growth to such a rate, the economy would almost certainly fall into recession. Nominal wages are still rising rapidly, and if business cannot pass along those wage increases in the form of higher prices, then businesses would sharply reduce employment.
The best way to avoid this dilemma would have been to keep the economy from overheating in the first place. That might have been done if the Fed had interpreted its “flexible average inflation target” (FAIT) of 2 percent in a symmetrical way — promising to make up for both inflation undershoots and overshoots. Unfortunately, it ended up with an asymmetric FAIT policy, only committing to make up for inflation undershoots.
Thus, it is now too late to avoid the need to attempt a highly difficult soft landing. If the economy were an airplane, it is coming in much too fast, leaving little margin for error.
The Fed’s best hope is to gradually slow nominal GDP growth, perhaps to a 5 percent rate over the next 12 months, and a 4 percent rate over the subsequent year. If we were to escape with a mini-recession (roughly 5 percent unemployment) and 2 percent inflation by 2024, it might not count as a soft landing, but by historical standards we will have escaped high inflation with relatively little damage.
Unfortunately, not only has the United States never had a true soft landing; we’ve never had a mini-recession. When unemployment begins rising during an economic slowdown, it always increases by at least 2 full percentage points. In contrast, mini-recessions often occur in foreign countries. The Fed needs to do a better job of steering a course between too much stimulus and too little.
Scott Sumner is the Ralph G. Hawtrey Chair of Monetary Policy with the Mercatus Center at George Mason University and a professor emeritus at Bentley University.