Caroline Baum: Fed could achieve the elusive soft landing if market forces don’t intervene

Could this be it? After multiple tries and a long list of failures, could the elusive soft-landing finally become more than a single data point in economic history, a result of human intuition and flexibility rather than adherence to mathematical formulas and econometric models?

With Jerome Powell, a non-Ph.D economist, in the driver’s seat, and with inflation M.I.A., this may be the best shot central bankers have to claim victory over the business cycle. The biggest obstacle this time around, believe it or not, is the market.

A soft landing is defined as the process by which an economy downshifts from above-trend growth to slower growth without entering recession.

In previous expansions, inflation was the spoiler. Central banks had to slam on the brakes to slow growth to restrain inflationary pressures in an economy expanding faster than its potential.

So while tipping the economy into recession was never the goal — except, perhaps, when Paul Volcker realized that the only way to whip inflation now was to send the economy into a hard reverse — it was almost always the result, given the long and variable lags with which monetary policy operates.

A Google search for “soft landing in economics” (as opposed to aeronautics) produces one success story, credited to then-Fed Chairman Alan Greenspan, in 1994-1995.

After an extended period of what was at the time considered to be an unusually low federal funds rate of 3%, Greenspan doubled the benchmark rate to 6% in a year’s time, from February 1994 to February 1995. The funds rate remained there, with some modest tweaks — up and down, but mostly down — until the Fed began to tighten to address the dot-com bubble in 1999.

This time around, the Fed has shown itself to be exceedingly flexible: reducing, then tabling plans for additional rate increases next year; warning about a synchronized slowdown in global growth and a variety of other risk factors, from trade wars to an uncertain Brexit; and preaching patience in determining the direction of policy.

The Fed has relaxed its focus on the Phillips curve, which posits an inverse relationship between unemployment and inflation that seems to be either dormant or dead. The Fed’s preferred inflation gauge, the personal consumption expenditures price index, has breached the 2% target in only a handful of months in the last seven years. Inflation expectations are below the Fed’s target as well.

This is happening at a time when any sugar-high from the Tax Cut and Jobs Act seems to be fading, with economists paring real gross domestic product forecasts for 2019 to an average of 2.2%, according to the Wall Street Journal economic forecasting survey.

At the same time, a robust jobs market, as evidenced by the January employment report, is drawing individuals back into the labor force. The prime-age labor-force participation rate rose to an eight-year high of 82.6% last month.

So what could go wrong to upset the apple cart, upend the best laid plans of the Fed for a soft landing and send the expansion — which would turn 10 years old in June and become the longest on record in July — into reverse?

Several possibilities come to mind, but only one seems viable in the current situation.

Unlikely catalysts

Let’s begin with the also-rans.

Inflation could rear its ugly head, forcing the Fed to tighten more aggressively. This seems unlikely, given that there have been no early-warning signs of demand-driven price increases from industrial commodity prices at a time when growth in China, Japan and Europe is slowing.

An all-out trade war? If the U.S. and China haven’t reached an agreement by March 1, on March 2 tariffs would increase to 25% from 10% on $200 billion of Chinese goods. China has agreed to buy more “stuff” from the U.S., but unless there is some progress on alleviating China’s unfair trade practices, the knives could come out.

It’s not clear that a trade war by itself would stymie U.S. economic growth. Exports constitute a relatively small share of GDP: 12.3% in the third quarter of 2018. That’s down from an all-time high of 13.7% in 2014. So foreign trade matters; it just isn’t the driver of U.S. economic growth. That honor belongs to consumer spending, which has accounted for more than two-thirds of GDP since 2001.

There’s always the prospect of another partial government shutdown if President Donald Trump vetoes the bipartisan deal reached by a conference committee late Monday to keep the government funded through Sept. 30. The true cost of any shutdown is in human terms — in the disruption to lives and livelihoods — not in the tenths of a percentage point it subtracts from GDP growth.

Stock-market meltdown

My guess is the main impetus for a contraction in GDP growth would come from financial markets. Specifically, if another stock-market meltdown SPX, +1.29%   or an international crisis, triggered by, let’s say, a messy divorce between the U.K. and European Union in March, sends investors running to the safety and security of U.S. Treasuries, the yield curve could invert in what traders call a “bullish flattener,” with long-term rates TMUBMUSD10Y, -0.10%  declining independently of any action on the part of the Fed.

How would the Fed respond? The term structure is already unusually flat, with a mere 25-30 basis points between the effective funds rate and the 10-year Treasury yield. The 10-year yield fell by more than 50 basis points in November and December as stock prices plummeted.

So it would not take much in the way of bad news to put the Fed in a position where it has to lower rates, not so much to address the crisis but to offset the reaction to it: a flight-to-quality into Treasuries that inverts the term structure and creates a disincentive to the lending and credit creation that drive economic growth.

Unless the Fed responds aggressively to such an inversion — and I’m not convinced policy makers will seize the day — it almost guarantees that Soft Landing 2.0 will remain a mere footnote in economic history, a case of what might have been, not a model for central banks to emulate in the future.

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