Where Is the U.S. Economy Headed: Soft Landing, Hard Landing, or Stagflation?

Where Is the U.S. Economy Headed: Soft Landing, Hard Landing, or Stagflation?

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INSIGHTi
Where Is the U.S. Economy Headed: Soft
Landing, Hard Landing, or Stagflation?
June 28, 2022
The Economic Recovery So Far
The recovery from the 2020 recession was rapid through the first half of 2021, but the transition to
moderate, sustainable economic growth has been choppy, with negative growth in the first quarter of
2022. Moreover, high inflation has complicated the path forward. Since March 2022, the annual change in
the Consumer Price Index has been above 8%.
To reduce inflation, the Federal Reserve (Fed) is raising the federal funds rate (a short-term interest rate)
to reduce aggregate demand (total spending). Since March, the Fed has raised rates from a range of 0-
0.25% to a range of 1.5-1.75%. This raises the question of how much demand needs to slow to restore
low inflation. This Insight discusses three scenarios for what might come next—a soft landing, a hard
landing, and stagflation.
Soft Landing?
Fed leadership aspires to restore price stability through a “soft landing,” where growth is moderate but
positive, and unemployment rises modestly, if at al . This is reflected in Fed leadership’s median
projection that inflation wil fal to 2.6% in 2023, while unemployment wil remain below 4%. Fed
Governor Christopher Wal er envisions a soft landing where firms reduce job openings instead of laying
off workers. Skeptics refer to this scenario as the “immaculate disinflation” because, under standard
theory, a sizeable and rapid reduction in inflationary pressures requires an increase in unemployment.
Soft landings are infrequent. Fed Chair Jerome Powel recently argued that soft landings occurred after
monetary tightening in 1965, 1984, and 1994, as shown in Figure 1, and that some other recessions, such
as in 2020, should not be attributed to tightening. However, inflation was low in 1965 and 1994, and
below 5% in 1984.
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Figure 1. Federal Funds Rate and Inflation
1960-2022

Source: Federal Reserve, Bureau of Economic Analysis.
Hard Landing? Stagflation?
After negative first quarter economic growth, some economists are forecasting a “hard landing,” where
rising rates causes the economy to reenter a recession. In fact, although not necessarily causal, every
recession since the 1950s has been preceded by an extended period of rising rates, sometimes with a lag.
Hard landings are more common than soft landings when, as now, inflation is high and the Fed is raising
interest rates. High inflation and low unemployment are evidence that demand is too high, and it has been
difficult to reduce demand in those circumstances without triggering a hard landing.
A hard landing could occur in two ways. If high inflation expectations become entrenched and a wage-
price spiral occurs, the Fed may have to overcorrect with tightening to restore price stability.
Alternatively, it could overdo it by tightening too quickly when inflation would have eventual y subsided
with less tightening.
Since the last recession ended in 2020, this scenario is also cal ed a “double dip recession.” Double dip
recessions are rare, but there are paral els between the last one in the early 1980s and today. The early
1980s was the last time inflation exceeded 7%. The second recession in that episode is widely attributed
to the Fed rapidly increasing interest rates, peaking at over 19%, to reduce inflation. Inflation had far to
fal to restore price stability, and therefore interest rates remained high until 1982, causing an unusual y
long and deep recession.

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To date, the Fed has not discussed raising rates close to 1980s levels, and it is debatable whether the Fed
would again be wil ing to keep tightening in a recession. The final scenario is that, for fear of triggering a
hard landing, the Fed does not raise rates quickly enough to restore low inflation. Thus, there is the risk
that successfully avoiding a recession now could lead to worse outcomes down the road. Once high
inflation expectations become entrenched, the relationship between inflation and unemployment weakens.
From then on, high inflation could be accompanied by low or high unemployment, regardless of whether
the economy enters a recession. High inflation and unemployment, last experienced in the 1970s, is
popularly cal ed “stagflation.”
Future Policy and Outcomes
Policymakers stil forecast that inflation wil be reduced relatively quickly on the grounds that, after 40
years of persistently low inflation, households wil view the last year as an anomaly and wil keep
expectations of future inflation low. This was not the case in the 1970s, however, and some data show an
increase in inflationary expectations since 2021. Once households expect higher inflation to persist, a
deeper recession might be needed to wring high inflation out of expectations, as was the case in the early
1980s.
The extent to which inflation expectations remain anchored depends largely on whether the Fed is wil ing
to raise interest rates as much as is necessary to rein in inflation. Although rates have been rising, they are
not high. As shown in Figure 1, the Fed has to date maintained negative real interest rates (i.e., nominal
interest rates that are lower than the inflation rate) in the face of rising inflation, as it did in the 1970s. The
Fed has been successful in reducing high inflation since 1960 only when real rates have been positive.
The Fed has raised rates rapidly since March but belatedly from a low starting point. As a result, the
amount of stimulus stil in place is large by historical standards, complicating a soft landing.
Future Surprises?
The broad direction of the economy since 2020 has been driven by factors outside the Fed’s (or federal
government’s) control—namely, supply disruptions caused first by the pandemic and, more recently, by
war in Ukraine. Until the pandemic ends, the path of the economy wil remain unpredictable. A soft or
hard landing could occur because of outside events instead of any action by the Fed. For example, a rapid
resolution of supply disruptions would ease inflationary pressures and boost growth, making a soft
landing more likely. Alternatively, if supply constraints take longer to resolve, at that point a soft landing
may not be possible because expectations of high inflation have already become endemic.

Author Information

Marc Labonte
Lida R. Weinstock
Specialist in Macroeconomic Policy
Analyst in Macroeconomic Policy

Disclaimer

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