Inflation still has a long way to fall but a 'soft landing' remains possible

The world’s most important central bank announced this week that it no longer expects to see a recession in the world’s largest economy. 

Jerome Powell, chairman of the US Federal Reserve, made the pronouncement on Thursday after delivering an eleventh rate hike which took US benchmark rates to 5.25% to 5.50%.

It was similar to the message delivered by New Zealand’s own central bank during the May monetary policy statement. The Reserve Bank lifted its gross domestic product forecast to include only the shallowest of recessions in 2023.

In the accompanying press conference, Reserve Bank governor Adrian Orr said it should be read as a forecast of flat economic growth. The Treasury had a similar forecast in May which showed NZ missing a recession, again by the thinnest of margins. 

New Zealand has, of course, had two quarters of negative growth which means it is technically in recession. Some might argue this means the ‘soft landing’ target has already been missed. 

However, two quarters of marginally negative economic growth doesn’t mean the economy has experienced the sort of severe downturn we might associate with the R-word. 

While many in New Zealand have been experiencing economic pain, others have remained relatively immune. The net effect has not been a significant decrease in economic output.

Wages have almost kept pace with inflation and the labour market has yet to show any signs of weakness, although many expect those signals to show up in labour data next week. 

Inverted yield curve 

One long-watched harbinging of recession is the yield curve, which charts the difference in rates paid on government bonds over different time horizons. 

Investors typically expect to be paid more interest for lending over a longer term, and so rates are usually higher on those bonds than on shorter-term bonds — this creates an upward sloping yield curve. 

However, the yield curve on both NZ and US government bonds has been inverted for more than a year. Short-term bonds offer higher interest rates than longer-term ones, which creates a downward sloping curve. 

This means investors expect interest rates to fall, which usually only happens when the economy is struggling. And so, an inverted yield curve generally signals a coming recession. 

If the bond market is correct, someone should tell the stock market. The S&P 500 has climbed over 18% during 2023 and is only down 5% from its 2021 peak. 

The S&P NZX 50 has not performed as well, however. It is up just 3% this year and 12% below its peak. But it has been rallying and is up 13% from the lowest point of 2022. 

Traders and forecasters may be getting over confident. As New York Times correspondent Jeanna Smialek pointed out this week, US recessions in 1989, 2000, and 2007 were all preceded by declarations of a ‘soft landing’. 

Headline inflation has been falling without a corresponding rise in unemployment, this has given many hope that the 2% target can be achieved without a serious slowdown. 

However, economists warn that ‘sticky’ core inflation in New Zealand won’t budge without some slack appearing in the labour market. Other economies are also facing this challenge. 

Softish landings

The phrase ‘soft landing’ has been used in economics since the 1980s and was particularly prevalent when former Federal Reserve chairman Alan Greenspan successfully engineered one in 1994 and 1995. 

In a recent paper, Alan Blinder—Greenspan’s vice-chair at the Fed—argued soft landings are not hard to find, if you are willing to be a little loose with the definition.   

Any tightening cycle which resulted in less than a 1% decline in Gross Domestic Product, and didn’t get officially declared a recession by the National Bureau of Economic Research, could be considered a “softish landing”. 

The US Federal Reserve has tightened monetary policy to combat inflation 11 previous times since 1965 and has achieved a softish landing in about half of them. 

NZ’s current conditions definitely meet this definition of “softish”, although with inflation still at 6% the actual landing remains a long way off. 

Blinder said the likelihood of landing the economy softly depends on how high the “plane” was flying before it began to descend.

“Alan Greenspan’s perfect soft landing in 1994–1995 did not bring inflation down at all; it merely avoided what was thought to be a potential rise in the inflation rate. Paul Volcker, in stark contrast, inherited a double-digit inflation rate in 1979, which he brought down to about 4%. It was a long way down, and the landing was rough”.