Larry Summers is concerned the economy is facing a hard landing as the Federal Reserve attempts to control inflation. , will continue to suggest that the Fed can do it all in terms of low inflation, low unemployment and a healthy economy. Recessions are inevitable, but history shows that soft landings are difficult.
Before we get into the details of our situation, let’s take a look at some background. During economic recovery, the unemployment rate gradually declines. A useful definition of a soft landing is a period of at least three years of low-inflation economic growth, even after the labor market has fully recovered from a recession. Surprisingly, there is no evidence that the US has achieved a soft landing, at least as far as economic data is concerned.
In the United States, most recessions occur within two years of the recovery in unemployment from the last recession. Instead of leveling off at “full employment”, the unemployment rate almost always begins to rise sharply shortly after reaching its natural rate.
The closest the US came to a soft landing was from 1966 to 1969, when the unemployment rate leveled off in the 3.5% to 4% range for almost four years. Unfortunately, inflation started during that period. A long period of both low unemployment and stable prices seems elusive, like a unicorn.
Oddly enough, this is not the case in other countries where soft landings are not particularly uncommon. Japan has a long history of very low unemployment and low inflation. A striking example of a soft landing occurred in the UK between 2001 and 2008. At this time, unemployment remained in the 4.7% to 5.5% range for seven years, and inflation remained relatively low. Australia has had no official recession between 1991 and 2020.
In some ways, the challenges facing the Fed are even more acute than in the past few economic cycles. For the first time since the 1980s, he allowed economy-wide nominal spending growth to dramatically outpace the rate consistent with his 2% inflation target.
Over the past two years, nominal GDP has grown at an annual rate of around 13%. In the first year of recovery from the COVID-19 shutdown, rapid growth in nominal spending was justified by the need to recover from a deep recession. However, in the second half of 2021, spending began to rise above the previous trend line and inflation rose dramatically.
Returning inflation to the 2% target would require keeping nominal spending growth below 4% per annum. But if the Federal Reserve immediately slowed spending growth to such a rate, the economy would almost certainly slip into recession. Nominal wages are still rising rapidly, and unless firms are able to pass on these wage increases in the form of price increases, they will cut jobs significantly.
The best way to avoid this dilemma would have been to keep the economy from overheating in the first place. Had the Fed interpreted its 2% “flexible average inflation target” (FAIT) in a symmetrical way, promising to compensate for both inflation undershoots and overshoots, it might have delivered. Hmm. Unfortunately, it ended up with an asymmetric FAIT policy that only promised to compensate for the inflationary undershoot.
It is therefore too late now to avoid the need to attempt a very difficult soft landing. If you compare the economy to an airplane, it arrives very quickly and leaves little room for error.
The Fed’s best hope is to slow nominal GDP growth gradually, perhaps to 5% over the next 12 months and 4% over the next year. Avoiding a small recession (unemployment rate of about 5%) and inflation of 2% by 2024 might not be considered a soft landing, but by historical standards, the comparative It means that high inflation could be avoided with a relatively small loss.
Unfortunately, the United States has not only never had a true soft landing. There has never been a mini-recession. When the unemployment rate starts to rise during an economic slowdown, it always increases by at least 2%. In contrast, foreign countries often experience mini-recessions. The Federal Reserve needs to fine tune the course of too much and too little stimulus.
Scott Sumner He is the Ralph G. Hawtrey Monetary Policy Chair of the Mercatas Center at George Mason University and Professor Emeritus at Bentley University.