The annual inflation rate in the United States is now about 6 percent, down from the nearly double-digit rate in the middle of last year. At the same time, the U.S. unemployment rate is 3.4 percent—the lowest it’s been in decades. That combination of datapoints suggests that the decision by the Federal Reserve to combat inflation by raising interest rates is not only working on its own terms, but might be accomplishing what’s referred to as a “soft landing” for the U.S. economy—a cooling down of inflation while managing to avoid a recession.
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Why have some economists expressed doubt that a soft landing is even possible? To what extent is the data telling a contradictory story about the U.S. economy? And will interest rates ever revert to where they were a few years ago? Those are a few of the questions that came up in my recent conversation with FP economics columnist Adam Tooze on the podcast we co-host, Ones and Tooze. What follows is an excerpt, edited for length and clarity.
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Cameron Abadi: In June 2022, former Treasury Secretary Larry Summers described a soft landing to inflation as “at odds with both economic theory and the empirical evidence.” What exactly did Summers mean by that—in what ways does this idea of a soft landing contradict what we’ve previously known about the economy?
Adam Tooze: So the theory bit is the idea that there’s a thing economists call the Phillips curve, which was first estimated for the postwar period and became very popular in the 1960s, which postulates that there’s a trade-off between unemployment and inflation. And the idea is that if you want to have inflation coming down, you probably need unemployment to go up considerably. And if it has to go up by a large amount, then you’re talking a hard landing. And so faced with inflation of the sort that we were dealing with two or three months ago, heading toward 10 percent and over, Summers’s proposition—and he made this very forcefully in a paper he did with a collaborator, Alex Domash—was to say, “Look, you know, we’re kidding ourselves if we think we can get inflation down from 10 percent by a substantial margin without unemployment going up by a large amount.”
And this is where the empirics came in. Since 1955, there has never been a quarter with price inflation above 4 percent—and we were well above 4 percent—and unemployment below 5 percent. And this is the situation of the U.S. economy: very tight labor markets, unemployment headed below 4 percent. So in Summers’s and Domash’s summary, since 1955, there’s never been a quarter with price inflation above 4 percent and unemployment below 5 percent that was not followed by a recession, a hard landing, within two years. Why? Because the Fed has had to act to repress inflation, which is above 4 percent. And when you repress inflation above 4 percent with that kind of a tight labor market, you end up having to induce a recession. In other words, two quarters back to back of negative growth. So it’s this combination of extremely tight labor markets and high inflation that led them to postulate that it was improbable that we could see a soft landing.
What we’ve actually seen in the months since then, and particularly over the last two or three months, is wage inflation decelerating very fast in the United States. Wage inflation was around 6.5 percent last year at various periods. Domash and Summers postulated that it was going to go over 7 percent and that was going to drive continuing inflation, and then the Fed would have to act. And instead what we’ve seen is wage inflation rapidly falling from 6.5 percent to, I think, the latest reading is 3.5 percent. So if that continues, then their story begins to crumble and the soft-landing scenario becomes more plausible.
CA: So potentially we are making some economic history here.
AT: Yeah. Whether we stick to existing patterns or perhaps we, in the wake of COVID, have experienced a true anomaly.
CA: In what ways is the data telling a contradictory story about the U.S. macroeconomy? It seems like consumer confidence is down, but at the same time, consumer spending is still pretty strong. When it comes to manufacturing data, factory orders are down, but as we’ve been discussing, unemployment is still at record lows. So do these kinds of tensions have to be reconciled, or is it possible to maintain this peculiar kind of equilibrium?
AT: Yeah. So this is a great question, and it’s been occupying folks in the markets and they’ve actually come up with an idea, a scenario, a term to describe this weird kind of balance of good and bad news. And that’s called the “No landing” scenario. But as Ethan Wu, the great journalist at the Financial Times and the Unhedged newsletter there has pointed out, this isn’t really an equilibrium, a situation that you can maintain.
Why not? Because inflation is still ticking along at between 6 and 7 percent. Now, that’s way, way down on where we were last year, like where we thought we were heading toward 10 percent. And wage inflation is off its peak and coming down. But regular inflation is still stubbornly stuck around 6 to 7 percent. And the core bit is actually not showing this tendency to deflate as quickly as we’d expect. That’s the bit that is the element of inflation that is least susceptible to shocks, like energy. And so this is what the Fed is tracking.
And so maintaining this equilibrium, this no-landing scenario, would essentially mean continued pressure on the Fed to do something. This would imply more kind of shilly-shallying and balancing and endless querying, and you and I doing endless podcasts about what the Fed will do. And in the end, this has to resolve itself into one of the other scenarios, namely a hard landing or a soft landing. It’s not until inflation comes down that we can say that we’re back to some kind of equilibrium, not because the economy and society couldn’t potentially tolerate 5-6 percent inflation—there are societies that have lived with that—but because we’ve got a powerful agent, an actor in the system, the Fed, that is mandated effectively, legally mandated, to get the inflation rate down to something closer to 2 percent. And while everyone in the system knows that there’s that big whale in the financial system that is motivated that way, then of course no one can really feel confident that the prevailing higher level of inflation and interest rates and so on would actually be a stable equilibrium. So in the end, we have to land somehow, and what that means is we have to have inflation down.
CA: Couldn’t the Fed just be patient? I mean, if the trend is working in this direction, can they just let it play out rather than …?
AT: Yeah, that is going to be the trillion-dollar question going forward from here is: How patient will they be? Because going from close to 10 percent to 6 percent and from 6 percent to 3.5 percent is the sort of trend the markets expect. The rubber will hit the road when the question is: What will the Fed do if inflation sticks at 3? And, you know, they really should be squeezing, squeezing, squeezing until we get to 2. And another option will be revise the mandate, and I’ve long been a supporter of the position argued by people like Olivier Blanchard, the French economist, formerly chief economist at the International Monetary Fund, who said, we really ought to revise the target for the Fed to 3 or 4 percent, which once upon a time was a sort of inflationary position; let’s avoid the stress of trying to get from 3 or 4 percent to 2. If you come back to this issue 12 months or 18 months from now, that might be the topic.
CA: So moving the goalposts is an option as well.
AT: Might be an option, yeah.
CA: If we have a soft landing, are we just returning to the economic situation we had before, or is there going to be some residue from this period of high inflation?
AT: I mean, this has been the puzzle about Summers’s position throughout. He’s an extraordinarily smart guy. But it seemed almost as though he suddenly saw the American economy as this very dynamic, cultish, bouncy thing that needed to be reined in really hard because otherwise inflation was going to run away from us. But Larry, a couple of years ago, weren’t you telling us that this dog don’t hump, like this thing just doesn’t go anymore? And so we keep juicing it with lower and lower interest rates, but it just won’t go because the investment demand isn’t there. And so which one of these two images of the economy should we actually go with? And the evidence seems to be—and it’s not necessarily a good news story; it just means that the inflation threat is less real than many people suggested—that we might actually be sort of drifting back to a lower-growth, lower-interest-rates kind of a world. But for Europe, I find that entirely plausible. I just don’t see a sudden surge forward in the underlying growth rate of the European economy, not even with all of the spending on the energy transition. For the United States, it’s just a little less predictable. But even so, you know, there aren’t that many people whose long-run real expectation of growth in the U.S. is much north of 2 percent, maybe 2.5 percent absolute maximum. And that isn’t an economy that generates very high interest rates over the long run.