Can We Really Have a Soft Landing?

In August 1982 I arrived in Washington to begin a year working at the White House Council of Economic Advisers. Yes, it was the Reagan administration, and I was already a liberal. But it was a technocratic position rather than a political one, and the council’s new chair, Martin Feldstein — a moderate Republican of a type that has largely vanished since — wanted some whiz kids to crunch the data. I was supposed to focus on international issues; the new hire for domestic economics was a guy named Larry Summers. What ever happened to him?

Anyway, Marty and I had a working dinner on my arrival night, and he had one big question to ask: “Is the world economy about to collapse?”

There were two main reasons for his concern. One was that Mexico had just announced it was unable to keep paying its debts, marking the beginning of the Latin American debt crisis. The other was that the Federal Reserve’s efforts to fight inflation had sent the U.S. economy into a tailspin, with the nation experiencing its worst recession since the 1930s, not to be rivaled until the financial crisis of 2008.

But as it turned out, the world economy didn’t collapse. The debt crisis produced a “lost decade” in Latin America, with widespread economic suffering, but it didn’t spread into a global contagion. And further north, a policy U-turn by the Fed eventually jump-started a rapid recovery; by 1984 Ronald Reagan was boasting about “morning in America.”

Still, the memory of that summer makes me a bit nervous about the economic optimism that seems to be breaking out all over right now, at least in the media. Predictions of a “soft landing” — inflation falling to acceptable levels without a recession — are proliferating. And my own prediction is indeed for a softish landing: Inflation does seem to be coming down, and while we might not completely avoid a recession, if we have one it will probably be mild.

But the experience of the early 1980s still offers two reasons for caution.

First, controlling inflation in the ’80s was extremely painful. Here’s what used to be the Fed’s preferred measure of underlying inflation (I’ll talk about recent problems with that measure in a minute) versus the unemployment rate from 1979 to 1985:

Inflation did come down, from around 10 percent to around 4 percent. But the process of disinflation involved a huge, sustained bulge in unemployment. In the economics jargon of the time, there was a very high sacrifice ratio. In late 1984, when Reagan was talking about how great the economy was, the unemployment rate was more than twice what it is right now.

Some people are talking as if we’re going to need to go through a similar ordeal again. At least until a few months ago, Larry Summers was laying out 1980s-type scenarios for disinflation, saying that unemployment would need to rise to close to 6 percent to get inflation under control.

I think he’s wrong. Pandemic-related distortions have made it much harder to estimate underlying inflation, to the point where we’re not even sure what the term truly means, but many of the measures that have been devised in an attempt to cut through the fog are showing moderating inflation even though we have yet to see a rise in unemployment. For example, here’s one measure from the New York Fed, multivariate core trend — trust me, it’s a smart, sensible approach, although not definitive:

If we believe this measure, or what seems to be a downward trend in wage growth, inflation has moderated substantially already — again, without a big rise in unemployment. So, as I said, I think Larry is being far too pessimistic. But am I sure? Of course not.

The other reason the experience of the 1980s still weighs on me is that it was clear in 1982 that the Fed had braked harder than it intended. That is, it was trying to slow the economy down — it had, in effect, deliberately caused a recession — but it didn’t mean to cause a recession that severe. The truth is that then, as now, policymakers were trying to manage the economy with limited, often out-of-date information and using highly imprecise tools.

Specifically, the Fed is trying to reduce inflation by slowing the economy, which it is doing in turn by raising interest rates. But there’s a raging debate over how much the economy needs to slow, how much rates need to rise to achieve a given amount of slowdown and how long rate hikes need to take full effect. I sometimes think of the Fed as trying to operate heavy machinery in a dark room — while wearing heavy mittens.

So, even if we don’t need a severe recession to get inflation under control, we might get one anyway if the Fed brakes too hard. There is, of course, the opposite risk: that the Fed will do too little and inflation won’t come under control. But I think the inflation news has been good enough to justify taking that risk by going easy on rate hikes at least for a while.

The bottom line? A soft landing has become much more plausible than it seemed a few months ago. But it’s not at all a done deal.

Quick Hits

Explaining that new inflation measure.

A view from White House staff on the inflation situation.

Financial markets are very optimistic about inflation.

Households, not so much, although they are improving.