U.S. Fed expects a soft landing. Don't count on it.: Gary Shilling

OPINION: Jerome Powell believes that the Fed can raise interest rates enough to get raging inflation under control without forcing the economy into a recession. The odds that he can pull that off are getting longer by the day.

In Congressional testimony on March 2, Federal Reserve Chair Jerome Powell said that “it is more likely than not” that the central bank “can achieve what we call a soft landing” in the economy. In other words, he believes that the Fed can raise interest rates enough to get raging inflation under control without forcing the economy into a recession. The odds that Powell can pull that off are getting longer by the day. 

History shows that when the central bank increases rates, a recession is almost assured. The Fed’s 12 rate-raising campaigns since the early 1950s resulted in 11 recessions, with the only exception coming in the early 1990s. What makes the Fed’s job extra hard now is that the inflation rate is so high. “To the extent that inflation comes in higher or is more persistently high than that, we would be prepared to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings,” Powell told lawmakers.

Increasing the odds of a recession this time is the Fed’s plan to reduce the almost US$9 trillion of assets on its balance sheet after it stops buying U.S. Treasury and mortgage-backed securities this month. Those assets have risen US$4.8 trillion since the pandemic commenced in early 2020. Powell said the reduction will be conducted “in a predictable manner,” largely through letting obligations it owns mature rather than outright sales. Nevertheless, this is a big reversal from the US$140 billion in asset purchases it had been making each month to support the economy through the pandemic.

Another sure sign of a recession is an inversion of the so-called yield curve, which happens when the interest rate on the 2-year Treasury note rises above that on the 10-year note. An inversion makes it unprofitable for banks and other financial institutions that borrow through deposits and other short-term markets while lending at longer maturities. That restrains lending and thereby depresses business activity. At present, the 2-year yield is 1.53 per cent, still lower than 1.84 per cent 10-year note yield, but the spread has narrowed from 1.07 percentage points on Dec. 31 to just spx0.27 point.

The Fed is between a rock and a hard place. If it backs off tightening monetary policy, it risks persistent inflation, spurring buyers of goods to expect more of the same, so they buy ahead of need. The result is pressure on inventories and production capacity, leading to further price hikes. That confirms expectations and induces more pre-buying, generating a self-feeding inflationary spiral. Such was the case in the late 1960s and 1970s.