Studying Business Cycle: Soft and Hard Landings

In the US, inflation is kept under close watch by the Federal Reserve which pursues the goal of maintaining stability in prices and maximizing employment. When imminent inflation is indicated, the Federal Reserve takes action by raising interest rates to slow down the speed of growth in the economy. This action, however, demands careful execution as an excessive increment in interest rates could result in a recession which is termed ‘a hard landing’ in the economic space. Therefore, the Federal Reserve needs to find a good balance that addresses the issue of emerging inflation without causing a recession, in what is known as ‘a soft landing’.

Soft and hard landings are essential to the stable state of the economy, and a proper understanding of what they entail is crucial for making informed judgments about the policies of the government, among other significance. This guide does justice to just that by giving a detailed explanation of both concepts.

The Fed’s Fight Against Inflation

Since the early 1980s, the Federal Reserve has had to deal with spates of inflation. In the first quarter of 2021, there was a 10% rise in inflation, as a result of the ease of the COVID-19 pandemic lockdown in 2020 and the fiscal and monetary stimulus, amongst other factors. In response to this, interest rates were raised by the Fed from March 2022 by above 5 percentage points. The result was a drop in inflation and a continuous rise in GDP.

There is a positive but cautious outlook among economists on the occurrence of a soft landing. The result of a survey conducted by the Wall Street Journal in October 2023 that included about 70 economists in the private sector showed a drop in the probability of a recession from 54% to 48% within the next year.

This was the first time since mid-2022 that the probability was put below 50%. 69% of the economists surveyed in August 2023 by the National Association of Business Economics opined a soft landing by the Federal Reserve, as against 30% five months prior.

Soft Landing Explained

Soft landing became a widely used term in the era of Alan Greenspan as the Federal Reserve chair, credited with executing a soft landing in 1994 – 1995. The term refers to the economic action taken by the Federal Reserve to tame inflation by increasing interest rates to stabilize the economy while avoiding recession. It is an attempt to curtail the pressure from an imminent or existing inflation without causing a rise in unemployment.

A prime historical example of a soft landing was that engineered by Alan Greenspan in the mid-1990s with the monetary tightening. The economy in the early part of 1984 was approaching its third recovery year sequel to the recession of 1990 -1991.

The unemployment rate was already witnessing a sharp drop to 6.6% from 7.8% in February 1994. CPI inflation stood at 2.8%, with the federal funds at 3%, resulting in rapid growth in the economy and dwindle in the unemployment rate.

This trend stimulated concern in the Fed of a potential reoccurrence of inflation, prompting them to increase interest rates. An action which repeated seven times in 1994 and resulted in a rise from 3% to 6% of federal funds. In 1995, the Fed further cut down on its key interest rate, as well as the federal funds rate three times on seeing an abnormal softening in the economy in a bid to prevent a rise in inflation. The effects of this action were remarkable.

Hard Landing Explained

A hard landing is an economic situation that occurs when the Federal Reserve raises interest rates too high or too quickly in an attempt to tame rising inflation, but eventually ends the economy in a recession. Common features of a hard landing are a rapid decline in the economy, higher unemployment rates, and a decline in economic activity.

There was a high rate of inflation from the 1960s that saw a doubling rise in 1974 with the easy monetary policy from the 1972 presidential campaign and the hikes in prices of oil credited to the OPEC cartel in 1973.

The rest of the 1970s saw a struggle among policymakers to tame inflation with no record of success. Paul Volcker was chosen in 1979 by President Jimmy Carter to succeed William Miller as the Federal Reserve Chair.

At that time, inflation was running at an annual rate of 11% and Paul Volcker was poised to bring it down and restore stability in prices. Volcker’s led Fed raised the federal funds rate which was the Fed’s key short-term rate to 19% between July 1980 to January 1981. That decision led to a deep recession that lasted 16 months with employment rising to 10.8%, a perfect example of a hard landing.

However, in 1983, Volcker succeeded in bringing inflation down to about 3%. Thus, paving the way for long years of economic growth with insignificant interruptions.

No Landing Scenario

Opposed to soft and hard landings, the possibility of a ‘no landing’ scenario for the US economy is a hotly debated topic, as the Federal Reserve moves to reduce inflation with several rounds of interest rate hikes. Notably, a ‘no landing scenario’ refers to a situation where economic growth continues despite the Federal Reserve’s efforts to control inflation through interest rate hikes, indicating a successful balancing act, sustaining growth without triggering a recession.

Bottom Line

The US Federal Reserve plays a crucial role in maintaining stability when it comes to properly managing the economy. The focus is often on controlling inflation to ensure price stability and maximize employment.

When faced with imminent inflationary pressures, the Federal Reserve employs a delicate balance, adjusting interest rates to moderate economic growth. Striking this balance successfully leads to what economists term a ‘soft landing’. However, a misjudged or excessive response may result in a recession, known as a ‘hard landing’.