The Fed has turned the corner and is now looking towards moving into easing mode. Low inflation makes this possible, slowing growth and significant external headwinds make it a necessity. However, the track record of successful soft landings is poor. In the current environment, the challenge is considerable given already low rates in a very mature expansion. The biggest issue however is uncertainty with respect to trade.

William De Vijlder June 2019

 

Transcript

 

The difficult art of soft landings

The press conference of Jerome Powell this week has confirmed what markets have been expecting for quite a while: the Fed has turned the corner and is now looking towards moving into easing mode.

This is made possible because inflation is well under control.

It is necessary, because the economy is slowing down, so by easing policy, the FOMC wants to sustain growth, that is, it wants to engineer a soft landing. It is also necessary because the US is facing external headwinds.

Realising a soft landing is difficult. It is generally accepted that the Fed has achieved only one true soft landing, under Greenspan in 1995, after the aggressive rate hikes of 1994[1].

The reason why it is difficult is that by the time it becomes clear that monetary policy needs to be eased, it’s quite likely already too late. This explains why the Fed is adopting a proactive stance now: “better safe than sorry”.

How rate cuts influence the economy

Rate cuts can influence the economy in various ways:

  1. Credit becomes cheaper
  2. Asset values increase
  3. This improves access to bank financing (collateral channel)
  4. This in turn may boost corporate investment
  5. Saving becomes less attractive which may boost consumer spending
  6. The exchange rate may weaken
  7. Confidence gets a boost because central bank sends a message that it will act forcefully to support growth.

More than ever, a soft landing is difficult

It can be argued that the successful soft landing of 1995, may have had something to do with the structural transformation that the economy was undergoing in the context of the IT revolution and its impact on productivity and growth. In addition, President Clinton had committed to a massive multi-year deficit cutting plan which turned out to be a mid-cycle slowdown.

Today, this situation is quite different:

  1. The room to cut policy rates is limited
  2. treasury yields have already declined
  3. corporate bond spreads are still quite tight
  4. the huge size of the budget deficit may end up becoming a market concern
  5. this expansion is reaching a very respectable age.
  6. In addition, uncertainty with respect to trade relations acts as a headwind.

[1] “In practice, the Fed has achieved only one true soft landing — in 1994-95, when, under the leadership of Alan Greenspan, it was able to slow the economy enough to cool spending and ease inflation pressure but not so much as to cause a big jump in unemployment” (New York Times, Economy Often Defies Soft Landing, By EDMUND L. ANDREWS, AUG. 11, 2006).