Where is the economy headed? With Ben Tal

Benjamin Tal: Well, the Federal Reserve (the Fed) is becoming more confident that a "soft landing" scenario is materializing nicely. Achieving a soft landing, where the economy stabilizes without slipping into recession after a period of monetary tightening, is rare and challenging to achieve. We can compare the present to the only post-war soft landing we’ve experienced, in 1995, to gauge similarities and potential outcomes.

In 1993, the U.S. economy was recovering from earlier crises, including the savings and loans crisis and the 1991 recession. With the unemployment rate falling quickly and capacity utilization rising fast, the Fed began raising interest rates in 1994. By early 1995, rates had risen by 300 basis points, to 6.05%.

Benjamin Tal: The current economic cycle shows many parallels to the events of the mid-1990s. Both periods saw significant bond market corrections and tightening cycles by the Fed. In the 1990s, the economy slowed but stayed well clear of contraction. Real GDP growth bottomed out at a 2.2% year over year pace in the fourth quarter of 1995. The economic response in the current cycle is similar but slightly more muted, though per capita it’s pretty much the same. This is happening even though tightening is more aggressive in this cycle.

Benjamin Tal: The effectiveness of monetary policy to regulate real economic activity appears to be diminishing over time. We can look at factors such as a flatter Phillips curve, which suggests that economic activity has a smaller effect on inflation. A decreased need for corporate leverage based capital expenditures, because of greater reliance on the service sector and high-tech manufacturing, reduces sensitivity to interest rate changes. For households, they’re carrying less debt and fewer are holding adjustable rate mortgages.

Benjamin Tal: Another similarity between the 2 periods is the divergence in global economic growth, with the U.S. economy a standout robust performer. This divergence led to a surge in the U.S. dollar in both scenarios. In turn, this holds back global growth and puts downward pressure on commodity prices, which are priced in U.S. dollars. Both trends are anti-inflationary.

Benjamin Tal: A key outcome of the 1995 soft landing was a surge in productivity in the late 1990s, driven largely by the dot-com revolution. The current cycle also shows promising signs of productivity growth, with output per worker surpassing the growth rates seen in the earlier period. Factors such as industrial reshoring, just in case inventories, a tight labour market and green-related costs are putting downward pressure on profit margins. This can pressure firms to maintain or improve productivity by replacing labour with capital. Artificial intelligence (AI) is well positioned to play a major role in that transition.

Benjamin Tal: Overall, the good news is that the U.S. economy is showing promising signs of achieving the second soft landing in peacetime history.

Ben provides more details on these ideas in the Eyes on the Economy podcast Opens in a new window..