What is a soft landing and will the US economy have one in 2024? These are the questions on investors’ minds today. With stock markets reaching all-time highs, the bet on a soft landing is getting bigger by the day. In this post, I cover what a soft landing is. I will also attempt to define factors that can make or break a soft landing in 2024.

The Federal Reserve Role Explained

The Federal Reserve has a dual mandate. It involves achieving maximum employment and stable prices. The Federal Reserve does so through changes in the money supply or interest rates.

The interest rate that the Fed controls is the federal funds rate. It is the rate at the overnight credit market for lending bank reserves. As for bank reserves, they are the smallest cash reserves that banks must keep in vaults as required by the Fed.

When the Federal Reserve wants to fight inflation, it tightens monetary policy. Inflation is usually a sign of excessive demand or insufficient supply of products. While the Fed has no control over supply, it can influence demand in the economy. To tighten monetary policy, the Fed raises the federal funds rate. This increases interest rates in the economy and makes credit more expensive.

What is an Economy Soft Landing vs. Hard Landing?

First, there is no official definition of a soft landing or hard landing. It is a notion popularized in 1970s after the moon landing by American astronauts in 1969. The idea behind a soft landing is to slow down the growth of aggregate demand in the economy and avoid a recession.

If the Fed takes out some steam, but not too much, it engineers a soft landing. This means lower inflation around a 2% target and no material increase in unemployment. Also, no recession or a very small one is a must for a soft landing.

Economists use up to a two-year period post-tightening to gauge if the Fed succeeded. If monetary tightening causes a recession, we have a hard landing.

Achieving a Soft Landing is Difficult

So, as we see, it is a very narrow path that the Fed must navigate to achieve an economy soft landing. It is like a holy grail of monetary policy. Why? There are two main reasons. 

1. Long and Varying Lags

The first reason is a long and changing lag between the Fed’s tightening and its effect on the economy. Moreover, it is very difficult to quantify the effect of interest rate changes on the economy. The Fed has some vague idea how its tightening affects inflation, GDP or unemployment. Economists use estimates from their theoretical models for this. But, these models can only guide monetary policy, an in no way predict precise outcomes. 

Let’s say the Fed raises the federal funds rate by 1%. This interest rate change will affect the economy in a gradual manner with a lag. First, nominal interest rates in credit markets go up with some delay.  For instance, interest rates on home mortgages, credit cards and car loans increase.

Next, households change their borrowing and spending behavior based on seeing higher rates. All this takes time of at least a year or longer. Moreover, households may not even respond to changes in interest rates at all. Other factors, such as expectations of strong economic performance and a lower inflation, may affect household actions.

For instance, households may expect strong job market and higher wages in the future. In this scenario, people may continue spending and driving inflation higher. Thus, the Fed’s tightening may have little or no effect at all on the economy. This may force the officials to crank up monetary tightening even more.

And, this is where the problem lies. These long and changing lags create the danger of human error. After all, people (not robots) govern the Fed. If policymakers see no effect from their monetary tightening, they may tighten even more. This creates a risk of overshooting. The Fed may increase interest rate too much causing a hard landing in the process.

2. External Shock Dangers

The other most important danger for a soft landing comes from external supply shocks. The Fed has no control over these shocks and they happen often and out of the blue. The most recent one was driven by the invasion of Ukraine by Russia in 2022. Ukraine is one of the top exporters of wheat and corn in the world. As you can imagine, the war caused disruptions of grain supply. Food inflation came next.

Another example of supply shock happened in 1973 when OPEC engineered an oil embargo. This caused gasoline shortages and led to a double-digit spike in inflation. The Fed had to tighten monetary policy in 1973, producing a hard landing in the process.

Examples of Soft Landing and Hard Landing

Let’s examine one case of a hard landing and one case of a soft landing. Alan Blinder, the Princeton University economics professor, wrote a paper in 2023. There, Professor Blinder examined a history of soft landings from 1965 to 2022 and identified 11 episodes of monetary tightening.

Of these 11 episodes, only one produced a true soft landing under Alan Greenspan after the 1993-1995 monetary tightening. All other episodes had either hard landings with recessions or somewhat “softish” scenarios.

Hard Landing of 1988-1989 Monetary Tightening

Consider a monetary tightening episode that happened in 1988-1989 and ended with a hard landing. At the beginning of 1988, the unemployment rate was 5.7%. The real GDP growth in the previous year was about 4.5%. But, the headline inflation began creeping up above 4%. The federal funds rate stood at 6.6%.

Alan Greenspan was the chair of the Federal Open Market Committee at that time. The Fed decided to begin monetary tightening in response to the perceived inflation threat. From 1988 to 1989, the federal funds rate went up and peaked at 9.85%. The inflation stabilized. Moreover, the real GDP growth began slowing down in 1989 through the first half of 1990. Things seemed to be going fine with the economy showing a real growth rate above 2%.

Unfortunately for the Fed, Iraq invaded Kuwait in August of 1990. This led to an oil price spike. The West Texas Intermediate Crude increased from $16/barrel in July to over $40 in a matter of three months in 1990. Inflation skyrocketed and pushed the US economy into the recession of 1990-1991. Of course, we can blame Saddam Hussein for this hard landing episode. But, it shows how a random event can wreck even the best-laid plans the Fed may have for a soft landing.

Soft Landing After the 1993-1995 Monetary Tightening

The only soft landing happened after the monetary tightening of 1993-1995 under Alan Greenspan. This soft landing episode made him a legend among central bankers.

At that time, the CPI hovered below 3% with the unemployment rate of 6.6%. Such numbers should not have called for any actions at first sight. But, the Fed was getting worried about inflationary pressures in 1993. So, the Fed decided to act.

Alan Greenspan announced the Fed’s first-ever target interest rate in February 1994. Before that, there were no public announcements. Investors had to play a guessing game by watching the Fed’s trades on the open market. Can you imagine that today?

As the interest rate rose from 3% in 1993 to 6.05% by 1995, nothing short of a miracle happened. The inflation remained flat at 3% for some time and later plunged to 1.5% in 1998. The economy continued chugging along with the average real GDP growth rate above 4%. Moreover, the unemployment rate continued on a downward path, reaching 3.8% by 2000.

Comparison of 1993-1995 Soft Landing to 2024

With these numbers in mind, let’s make comparison of this economy soft landing episode to what’s happening today. After all, there is a lot of context to all this.

1. Inflation Differences

The first thing to notice is that the Fed was not trying to fight inflation in 1993-1995 unlike today. The CPI peaked at about 9% in 2022, which was the highest reading since 1980s.

I know that I am showing you here the headline CPI inflation. This is not what the Fed tracks. The Fed targets the core inflation based on personal consumption expenditures. This metric strips out the volatile effect of food and energy prices. The reason is simple: monetary policy has little influence over them. But, let’s roll with this analysis since the CPI attracts most public attention.

The Fed began hiking rates from 0% in 2022 to 5.33% in 2023 to fight the raging inflation. This was a massive tightening given that the federal funds rate was below 2.5% or even 0% for the past 15 years. For this reason, the risk of overtightening is not something to ignore. Conversely, in the 1993-1995 episode, the interest rate started from 3% and rose to 6.6%.

2. Supply Shocks

The second difference is that there were no major supply shocks for five years after 1995. That is not the case today. The price of crude dropped from $60 pre-pandemic to negative value and then shot up to $120 in 2022.

The US economy still depends on oil and these price shocks affect even core inflation at some point. This volatility is likely to continue given wars and conflicts in the Middle East.

As you may know, the US had to even weaken sanctions against Venezuela to let the heavy crude oil flow. While the US is one of the largest producers of oil in the world, most of it is light crude oil. The US is still dependent on imports of heavy crude oil from other countries. Heavy and light oil have different uses and the US economy needs both.

Other supply shocks, such as the war in Ukraine and supply chain problems did not help either.

3. Global Trade

The third difference between 1995 and now lies in globalization and trade. Trade and outsourcing manufacturing arguably brought cheaper prices to the US back then. Conversely, we observe reshoring and changes to supply chain after the pandemic. Covid-19 exposed flaws in logistics and compelled firms to change their supply sources. Of course, this effect is very hard to assess quantitatively as it is still happening today.

4. Productivity

The fourth difference could be productivity. Computers and internet began their rise in 1990s culminating in dot.com boom and later bust. The period of 1995 to 2000 showed a steady and robust growth in labor productivity. As for the last 10 years, the labor productivity stayed below 2%.

While the data is somewhat noisy, we can still see the difference. As for the spike in labor productivity in 2020, it was an artificial one. Most of the job losses in 2020 came from low-wage industries, such as hospitality and leisure. That is the reason behind this temporary increase.

You may be wondering why I am bringing up productivity. The thing is that productivity can lower inflation while helping the economy grow. As labor gets more productive, the output and companies’ profitability grow. This allows companies to increase wages, while keeping prices unchanged.

A low labor productivity observed today is not helping the Fed. Some commentators say that generative AI will propel productivity higher. While we can argue about that, we do not know what will happen at this point. It may or it may not help. It all depends on adoption rates and AI usefulness in the broad economy. 

5. Fiscal Stimulus

The fifth difference is the massive fiscal stimulus that happened in 2020-2021. None of that happened from 1995-2000. The government sent stimulus checks totaling $814 billion. This accounted for 3.5% of the nominal GDP of $23 trillion in 2021. This was huge.

Of course, the goal of stimulus checks was to replace lost wages from shutdown. But, not all people lost their income and they still got these checks. According to NBER, about 30% of households saved their stimulus payments, while 40% spent them on consumption. The remainder of 30% were used to pay off debt. This fiscal stimulus and excessive money printing most likely contributed to inflation we saw in 2022-2023. Post-2020 fiscal stimulus also led to higher budget deficits.

Conversely, the period of 1995-2000 had none of that. Actually, there were budget surpluses from tax increases, defense cuts and economic boom.

Investors Takeaways

So, as we see the differences between now and 1995 were rather stark. The question is: can the Fed repeat this feat and engineer an economy soft landing again in 2024? The answer is: we do not know. We are still in the middle of it. The Fed signaled in December 2023 that they are likely done raising interest rates. So, at least several years need to go by for the US economy to digest this tightening.

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What we observe so far is this. Inflation slowed down and the labor market remains healthy. Recently, the stock market peaked with many major indices reaching their all-time highs. We may speculate that the market prices in a soft landing at these levels.  

Still, many things can go wrong. What I have in mind are various external shocks that can ruin the Fed’s plans. These include oil supply constraints, possible trade wars and armed conflicts in the Middle East. Moreover, the aggregate demand can slow down faster than the Fed anticipates.

If the Fed did too much tightening, a hard landing is just around the corner. With soft landing priced to perfection, any disappointments can crash the stock market. Or, it can at least cause a lot of volatility. To bring a soft landing, the Fed must be not only highly intelligent and skillful, but also lucky.

Do you have any of your own reasons why a soft landing can succeed or fail in 2024-2025? Please let me know in the comments. I am very curious to hear your perspectives.