Currently, this is probably the important question in the minds of investors. Can the US Central Bank (more commonly known as the Fed) avoid a hard landing or, in other words, a recession? Let’s examine in detail the current situation, and the impacts it could have on the economy and the financial markets.
Definition of a soft or hard landing
The primary mandate of central banks is to maintain price stability and, secondly, employment stability, or full employment. We know that currently inflation is a major problem and that the US central bank is struggling to reduce it. Therefore, this has effects on the economy and also the financial markets.
Generally, the Central Bank will take two types of measures:
- Managing the key rate (raising/lowering rates);
- Inject (print money) or withdraw liquidity by reducing its balance sheet.
The very principle ofa soft landing, Where “soft landing”, means that the monetary policy of the FED (US Central Bank) will not cause a recession following the increase in rates to control inflation. Therefore, it is not going to affect growth to the point of leading to a recession.
However, in contrast, a hard landing, or recession, means that the monetary policy (increase in rates) will impact economic growth and therefore, consequently, have an impact on the financial markets.
The key rate, an important source of economic cycles
We know that economic growth is largely stimulated by debt and therefore interest rates. Interest rates / credit create economic cycles. This is why it is important to understand the ins and outs of the key rate of central banks, because the management of it can have consequences, such as a recession for example.
The rates impact several points:
- The personal consumption of individuals;
- The real estate market;
- Companies’ access to credit, which impacts their growth.
Since the policy rate is a major factor in the economy, it is important to pair it with growth.
To illustrate this more visually, here is a chart showing the FED rate spikes that preceded the recessions of 1990, 2001, 2008, and 2020. You can see that in the majority of cases, this caused a recession several months after ( see vertical line in purple).
In the majority of the cases given above, the key rate is at the peak of a bull cycle and this leads to a recession thereafter. This can indeed have a major impact on the economy since if growth is not strong enough, it cannot absorb it. Consequently, this affects personal consumption, the real estate market, businesses (production), income and employment.
That said, the impact of the peak of the bullish cycle of a key rate does not lead to a recession the month after, it takes time to set up. This is why when studying the macro elements, it must be understood that the time required for completion can take several months. But it allows us to be more vigilant.
There are of course cases where the Fed was able to avoid a recession via a soft landing. Let’s give an example:
- 1994-1995, we can see a peak in the key rate and a pivot of the FED thereafter. This can be seen by the stabilization on the graph of the rate in the years that followed. When we look at the growth in parallel at the time of the events, it was around 3-4%, which left the possibility for the economy to absorb the rates well.
And since inflation was around 2% (see graph), the FED did not have the imperative to continue raising rates to fulfill its main mandate. As a result, the economy rebalanced and US financial markets rebounded to new highs.
Will the Fed pivot too late?
As long as inflation remains high, there needs to be a strong reason for the Fed to pivot. A few examples that could justify this reversal of the situation:
- Increase in unemployment towards a less tolerable rate for the economy (above 5%);
- Lower inflation towards the target rate;
- Liquidity crisis.
Of course, one may go with the other. For example, having a cash crunch within credit can lead to bankruptcies. As a result, we would see a rise in unemployment followed by a fall in demand and therefore inflation.
As we know that the key rate impacts growth, it is important to know where the growth rate of the major factors of the economy is currently. For the moment, if we take the coincident indicator, we are still around 2% (see chart).
Which implies that we are still not in recession since the growth rate is not negative, but the key rate being higher than the growth rate, and inflation still high, this will probably push the growth rate towards 0 %. It is in this type of situation that we can look at leading economic indicators such as the ” Conference Board “. You can see that this one is quite negative.
(Economic leading indicators give us direction)*
The more we move towards a growth rate of 0%, the greater the risk of recession. This is why one might think that inflationary pressures could push the FED to pivot too late knowing that it is based on lagging economic data like the PCE.
To avoid a recession, we want to know if growth will persist, but, with inflationary pressures, the FED will not have as much flexibility to revive growth via a rate pivot.
If it is not the debt (low rates) that will revive the economy, we can look at the measures taken by the government, such as modifying corporate taxation or providing fiscal stimuli.
The current stimuli put in place by the government to counter inflation, such as “the act against inflation ” Where ” repay part of the student debt remain inflationary measures, because all stimuli remain inflationary since it pushes consumption. Therefore, it remains a vicious circle. Since as long as inflation persists, the Fed must act and remain restrictive. Its priority remains price stabilization and not growth for the time being.
Conclusion
The soft landing theory (avoiding a recession) is becoming more and more refined. The restrictive policy of the FED in the midst of a slowdown in growth will not help it to rebound. And since inflationary pressures are present, this prevents the FED from pivoting and acting to revive growth.
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