Since we gave up on the idea that high inflation would be transitory, the hope has been that we would manage a soft landing: Inflation would melt back to 2% without doing too much harm to the labor market or economic growth. That’s what the Federal Reserve has predicted for months, even as economists warned it was extremely unlikely. Now it seems a soft landing is a real possibility. Inflation is falling and the labor market remains strong with unemployment at a 50-year low and wage growth of 4.6%.
If these trends continue, the “immaculate disinflation” the Fed projected will become a reality. But don't celebrate yet. That won't mean we dodged a bullet.
A soft landing would clearly be better than a hard one. A hard landing means a lot of people would lose their jobs and then the terrible labor market would bring down inflation. Some of the more encouraging aspects about today’s job market are that unemployment is so low among people with a high-school education or less, and much of the job growth is happening in smaller businesses. In a recession, those are the groups that are hurt most.
Yet the labor market isn't quite as good as it looks. Nominal wage growth might appear high, but after accounting for inflation, many households — especially-lower income ones — are still getting poorer. Many were better off when nominal wage increases were lower, but inflation was, too.
The problem with a soft landing is that it will drag out this inflation cycle. That means more months (or years) where wages won’t keep up with rising prices, pushing some households further into debt. One reason some people have been optimistic that a recession would be mild is that household balance sheets were in such good shape coming out of the pandemic. But the longer the slog out of inflation, the more households will burn through their savings. There already is evidence that they are running up credit card debt.
A drawn-out soft landing also means higher interest rates for longer, which could destabilize the financial system or pose problems for companies that have become dependent on cheap debt. This scenario also will be harder on small businesses because they have less ability to increase prices and less access to credit.
Another risk with a soft landing is that the cycle will be incomplete. It might be that inflation improves but then stalls around 4% or 5% while the labor market remains in a good place. At that point the Fed would be left with a difficult choice. Inflict real damage to get inflation back to 2% at a time when the economy is in a more fragile place. Or, the more likely outcome, the Fed just learns to live with higher inflation and takes the win.
But living with moderate inflation also poses costs. It shows the Fed can’t meet its target and the central bank loses more credibility. It needs that credibility to have an impact on the economy in the future (including boosting the economy in the next downturn). Above-target inflation also means higher interest rates for the foreseeable future because bond buyers will need more yield to compensate for more inflation risk. Higher rates for the long term will translate into higher mortgage rates and a bad shock for both domestic and foreign markets.
Nonetheless, if the soft-landing scenario bears out, the economy will probably muddle through without too much damage as long as it doesn't suffer another major jolt. And that's a big if. The global economy is much more uncertain than it was before the pandemic. A few sources of concern are:
1. Political dysfunction. A divided Congress and a weak speaker of the House of Representatives will be less likely to be able to pass budgets and cut spending as needed. The risk of actually defaulting on debt is low, but chaos in Washington adds uncertainty to the US economy and can lead to even higher interest rates and a weaker dollar.
2. More disease. The Covid-19 pandemic is largely over, but you never know what could emerge in terms of variants or new viruses.
3. Political risk abroad. Things could get worse in Russia or China. Higher rates also pose many problems for emerging markets. All of this could create more supply chain issues and higher energy and food prices.
Those are just the threats we can readily imagine. The biggest risk from a soft landing is that it undermines the economy’s resilience to future shocks, which leaves us more vulnerable for longer to whatever comes next. It might be better than a bad recession in the short run, but the multitude of hazards shows why high inflation is so hard to manage, and why it can cause so much damage for years to come.
Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.”