This time last year, the consensus among professional economic forecasters expected a recession. Some experts like former Treasury Secretary Larry Summers said we “needed” higher unemployment to get inflation down. A soft landing — avoiding a recession and getting inflation down — was seen as impossible. Those experts were wrong. The soft landing is in sight. Inflation fell from a 9% annual rate in the summer of 2022 to 3%, unemployment has had its longest run under 4% since the 1960s, and consumer spending, inflation-adjusted, rose at a fast clip.
What 2023 showed was that the ‘impossible’ was not only possible — which I have always argued — but is reality. We are not at the soft landing yet, but we are getting close.
Federal Reserve Chair Jay Powell is not flying the plane, despite the popular narrative.
But it’s important to understand how the economy got on course for this soft landing. Federal Reserve Chair Jay Powell is not flying the plane, despite the popular narrative. He’s sitting in first class but giving the Fed credit means we could learn the wrong lessons — in particular, leaving interest rates too high for too long.
To his credit, Powell never said we needed a recession to get inflation down. That was crucial because the Fed knows how to cause one, as his predecessor Paul Volcker did in the early 1980s. But the Fed has been largely irrelevant on inflation this time. It fights inflation by raising interest rates, which reduces demand but does not increase supply. The recent main drivers of inflation, however, were supply-driven disruptions from the pandemic and later the war in Ukraine: supply chains freezing up, millions of workers dropping out of the labor force, a rapid shift to spending on goods from services, and energy shortages.
Powell did not unload the docks in Los Angeles, take a second job, give vaccine shots or drill for oil. These people are the ones who brought inflation down in 2023. They are the ones flying the plane.
After waiting during 2021 for supply disruptions to unwind, the Fed raised rates sharply in 2022 and then gradually in the first half of 2023. If the Fed had been behind the drop in inflation, then unemployment would have risen, and consumer spending slowed. It did not.
Also, the Fed did not ‘talk down’ inflation with its credibility as an inflation fighter, as some macroeconomists assert. The theory says that if people start to expect higher inflation — referred to as “de anchoring”— a self-fulfilling prophecy can occur. One channel would be that workers expect higher inflation, so they demand higher wages now, which leads to price increases by businesses. In reality, wages for most workers rose after actual inflation. Moreover, the increases in inflation expectations in 2022 were related to higher gas prices, and the two moved down together, too. That’s not the Fed.
Inflation is moving down fast toward the Fed’s target of 2%; it’s time to start cutting rates.
Of course, economic events as complicated as the past four years have reflected a mix of factors. Some of the inflation was demand-driven by massive pandemic relief from the federal government and the pent-up demand due to the shutdown of the economy. Interest rate increases should have an effect. But that effect appears modest, at least so far.
The Fed did make two big contributions, however. First, it served as the lender of last resort. After opening 11 new lending facilities to stabilize markets at the start of the pandemic — more than twice as many as during the 2008 financial crisis — last year the Fed stepped in when Silicon Valley Bank failed. Its actions contained the spread with only two other bank failures, averting a widespread crisis in financial markets.
Second, the Fed understood the unprecedented nature of the crisis and the role of supply disruptions in inflation. Not raising the federal funds rates in 2021, even as inflation began to climb, maintained a tailwind to the robust recovery. Then two more waves of Covid, a war in Ukraine and a slow unwinding of the supply disruptions and labor shortages pushed inflation higher than expected. The Fed stepped in aggressively in 2022 with rate increases but continued to expect that rebalancing of supply was crucial.
All that said, the Fed is the biggest risk to soft landing next year. There is an intense debate over when the Fed will cut rates next year and by how much. Inflation is moving down fast toward the Fed’s target of 2%; it’s time to start cutting rates. Currently, 30-year fixed mortgage rates are well above 6%, which is about 2.5 times the low in 2021, and credit card and auto loan rates are even higher. The longer the Fed waits to cut, the greater the burden on families or small businesses looking to borrow. If people have to pull back on spending and investment too much, we could end up in a recession.
While grappling with these tough questions internally, the Fed must clearly communicate its plan to financial markets. After years of bad surprises, if the Fed surprises markets, it could end up ‘breaking’ something. The Fed contained the fallout from SVB's failure, but we might not be so lucky next time. A financial market crisis could fall back into the economy, as it did in 2008.
If the Fed keeps interest rates too high for too long, we could still miss the soft landing and end up in a recession. The Fed would fail at its job: maximum employment and stable prices. From Powell to President Joe Biden to millions of American families, no one wants that.