Walking the Tightrope: Preparing for a Soft Landing
The Chance of a Soft Landing and the Fed's Role in Facilitating One
“The universe does not behave according to our pre-conceived ideas. It continues to surprise us.” — Stephen Hawking
The Fabled Tightrope Walk
Tightrope walking has a rich history of fame (and sometimes riches) due to single events that changed the course of the performer’s life. Legendary figures could be born of – quite literally – walking a line between life and death. Spectators could not help but watch as the circus acts began performing in quite precarious situations. Three inches wide, 1,000 feet long, and drooping 60 feet towards the center stretched the tightrope Charles Blondin used to cross the Niagara Falls in 1859. With practically zero room for error, the performer walked across crossed the American-Canadian border simply utilizing a high wire. Blondin executed this act numerous times, adding variations and additive antics with each new approach. It was a daring performance for such an intimidating natural landscape. The Great Lakes account for roughly one-fifth of fresh water, globally – four of which feed into the falls. Excluding the water diverted for hydro-electric energy generation, approximately 700,000 gallons of water flow over Niagara Falls every second.
Masses of people took buses and trains into the state of New York to observe this man known as Blondin. Often identified as history’s most famous funambulist, Blondin made himself a name for his flashy show of coordination and biomechanical prowess. Funambulists (also known as tightrope walkers) are faced with the task of dynamically balancing their center of mass and moment of inertia. The concept is a measure of an object’s resistance to change in rotation direction. In other words, it describes how much a process could be angularly sped up or slowed down within its system; a large moment of inertia implies little angular acceleration. For a tightrope walker, this means little wobbling back and forth over the tightrope. Blondin was seemingly an exceptional physicist. The physics when put into practice became a must-watch spectacle and Blondin knew this. The Smithsonian Magazine writes, “Charles Blondin understood the appeal of the morbid to the masses and revelled when gamblers took bets on whether he would plunge to a watery death.”
Morbid, not as much, but the masses are tentatively watching Chairman Powell as he attempts to recreate Blondin’s historic act. He knows this. Some will try to tell you the current environment is like the ‘70s, ’94, and other periods – why can’t it be 1859 again? On the left side of the tightrope is deflation and the other is runaway inflation. With this scenario comes a very small moment of inertia and a tendency for the Fed to over rotate into a recession. Historically, the Fed is known to engineer recessions with tightening cycles. Fiscal policymakers, investors, and economists have found common ground in criticizing the U.S. central bank. Consensus appears to be this: the Fed has destroyed its credibility and its ability to tame inflation without a recession. A quick look at Google search trends shows that searches for “recession” reached its highest point since March 2020 near peak popularity, as defined by Google Trends.
The counterpoint has not been a fan favorite, and Powell himself, is making it more difficult to craft a nice picture where the Fed lands the inflation plane softly without tearing up the landing strip and knocking out the terminal building along with the control tower. Powell most recently alluded to the idea that the FOMC does not understand inflation or its drivers! In Powell’s own words, “it’s gotten harder, the pathways have gotten narrower,” to pull off the so-called soft landing. These two acknowledgements by Powell are significant in the development of the Fed’s rhetoric.
So, what is a soft landing and why are Fed watchers convinced of an aggressive recession? With a narrow pathway to success, how might a soft-landing look with this level of tightening? The Fed is undoubtedly stuck between a rock and a hard place. Let’s start with the soft landing. Cambridge Dictionary defines a soft landing as the following: a period when economic growth slows down, but the economy does not enter recession. UC Berkeley extends this condition to “the condition when an economy shifts from rapid growth periods to slower, even flattening growth periods.” The economic shifts in the past two years have been nothing shy of rapid. With oil falling to -$40 a barrel, unemployment at 14.7%, and GDP falling by 8% in 2020, it is pretty safe to say these figures recovered fairly quickly. Most recently, a barrel of oil is priced at $111, unemployment is at 3.6%, and GDP grew at a modest 10.7% year-over-year in Q1. Along with such a “recovery,” inflation has reached record levels – the elephant in the room.
This environment is somewhat of the Fed’s worst nightmare: inflation whose primary drivers are problematic supply chain developments and fiscal irresponsibility. A symptom of the pandemic has also been a slight change in the behaviors of consumers. Of course, the Fed is tasked with taming this inflation as a part of its dual mandate (easing the jobs of politicians skating by under the guise of sustainability). Although the Fed has been through 16 other tightening cycles, this one might actually be different. Of those 16 monetary tightening cycles there is one commonly noted success story of a soft landing: in 1994, Alan Greenspan hiked rates nearly 300 basis points without materially impacting the unemployment rate or causing a recession.
There are many facets of global markets that need to be considered in order to understand the present underlying dynamics. This is not just a matter of consumer prices, unemployment, the money supply, or the conflict between Russia and Ukraine. Markets are forward looking; if you have read 5 articles on the same subject, it is likely priced into financial markets. Let’s start with the obvious. As measured by CPI, inflation remains elevated at an unusually high level. Broadening contribution from CPI components met with services inflation has quietly made this possible. But there is always another story to tell. Core PCE (year-over-year) inflation has fallen consistently through June. Meanwhile, breakevens are displaying a much different dynamic. The 5 year TIPS/Treasury breakeven rate is calculated as the difference between the 5 year treasury rate and the 5 year treasury inflation-indexed security rate. Market participants use this value as what they believe the expected inflation should be in the next 5 years, on average. As can be seen, despite the belief that the Fed has destroyed its credibility and ability to address its mandate, financial markets are pricing in oncoming disinflationary forces.
Credibility in the Market
Another notable feature is the 3-month change in breakevens, which amplify the narrative for an increasingly disinflationary environment. Breakevens rapidly corrected downward in recent months along with other economic indicators. Joe Weisenthal noted this in a recent Bloomberg article, citing two possible explanations: 1) inflation is transitory, or 2) the Fed’s commitment to price stability will induce a severe recession.
The Development of Credibility
With meaningful decreases across the entire breakeven curve, one needs to ask what data is being reflected and interpreted within these numbers. Let’s back into the microstructure of the economy starting at the top. GDP forecasts have been revised downwards several times this year. Across the board, forecasters have revisited the growth outlook for the United States following the 1.6% decline in real GDP posted in Q1. Another quarter of negative GDP growth would not necessarily mean we are in a recession according to a revised NBER definition. The body that declares recessions has altered the characterization to the following:
“A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough.”
There needs to be broad weakness in the economy observed within the components driving GDP; a negative movement is no longer enough. Income, employment, industrial production, and sales now require significant reductions in activity to classify the macroeconomic environment as a recession. Unemployment remains extremely low at 3.6% – not a very recessionary figure. And although slowing, real personal income excluding transfer payments grew 1.8% year-over-year. However, manufacturing figures are looking much less impressive with time. Capex is falling relatively quickly according to the Fed’s regional surveys.
All in Moderation…
Along with weaker manufacturing, S&P Global is reporting supply shortages to be reaching 17-month lows. Price pressures according to raw prices and PMI figures are lightening to the weakest prints in almost 2 years. With that being said, PMI remains well above recessionary levels. S&P attributes easing pressures to improvements in transports and restrictions lifting at ports.
A Dynamic Duo: Easing Pressures in Supply 150 basis points into Tightening
The NBER states it will no longer identify peaks in activity until months later using the approach implemented in 2021. Speculators like to suggest that ISM figures and a negative Q1 GDP print point to the US already being in a recession. It does not seem to be that simple this time. With no official declaration and mixed macro data, there is still a window for the Fed to cross the tightrope over Niagara Falls.
Bear with me while we walk through a soft(ish) landing scenario. The pathway is narrow, but it is possible. With recession talk occurring every day, it pays to take time to understand the non-consensus view. This is increasingly important as the Fed begins to recognize the risk of overtightening into a depression. Expectations truly guide this market. Jon Turek takes note of this on Twitter.
For those laughing at the Fed over the past year, why are they no longer laughing? How does a new message prove to be credible all of a sudden? As suggested by Weisenthal, breakevens are a live demonstration that the Fed has credibility despite the noise. Markets are pricing a transitory bout of inflation. Gravity is beginning to set in specific sectors while the Fed is tightening policy and raising rates. Data is beginning to roll over. True Insights took notice of the serious drawdowns in commodities from their 52-week highs.
Blood in the Water
Coincidence? Perhaps. As you are reading this, oil has tanked 8% on the day. The tightening has yet to have a substantial impact on CPI. Inflation has proved stickier than previously thought. Interferences from geopolitical conflict and sustained demand have forced prices to stabilize higher for the time being. But inflation prints are also lagging indicators. As seen in the chart above and the precipitous fall in national housing prices, along with rent, there are material disinflationary forces developing.
Housing Taking Notes on Fed Meetings
The secular price cycles in commodities and housing are eerily reminiscent of the 2008 recession, but the market structure is vastly different. Banks are passing stress tests, household wealth remains at elevated levels, and corporations have stockpiled cash.
This Time is Different
Unemployment rises to 10% and GDP slumps drastically. Asset prices follow GDP and commercial real estate plummets – how do the banks fare? This is the hypothetical situation for the banks’ stress tests. Total losses are projected to be $612 billion, but banks demonstrated strong capital levels so there is nothing to worry about! Maybe, if you are a bank. But there is no systemic risk in the banking system. In 2008, the banking sector incurred massive levels of leverage and maintained abysmal risk management processes. The bubble was isolated to structured products, not housing. This time, it truly is the real estate market that is hot.
The past two years have been huge profit generators for major corporations – not necessarily in the way politicians make it out to be – with consumer balance sheets allowing for higher prices to be passed along. Even normalizing, corporate profits grew at 12% YoY in Q1. In a recent market update, Moody’s explained that default rates are still exceptionally low and most of their actions are credit upgrades. Look to the energy sector for evidence of these upgrades. In fact, 70% of total changes were upgrades in the beginning months of 2022. The crypto space retains the spotlight for regulatory troubles and credit downgrades – proceed with caution. For consumers there is a similar feeling. Consumer balance sheets are said to be strong, but much of the assets are made up from housing and other financial assets.
With corporations and consumers relatively strong and disinflation in goods prices, the soft landing is almost in sight. The keys to a soft landing are within the labor market and fiscal policy. Akin to the 1967-1969 and 1988-1989 cycles, there are lessons to be learned. Fed watchers like to posit that there is only one soft landing, but Alan Blinder refutes this, suggesting there is a case for seven episodes of “pretty soft” landings. In other cases, the FOMC did not even attempt to engineer a soft landing.
In the instances of 1969 and 1989, fiscal tightening played a major role, and a recession was caused by geopolitical risks. Blinder notes a very important point in his analysis of the 1967-1969 cycle. At the time, the Economic Report of the President was still produced. The 1968 report read as follows:
“It has been and remains the conviction of both the Administration and the Federal Reserve System that the Nation should depend on the fiscal policy, not monetary policy, to carry the main burden of the additional restraint on the growth of demand that now appears necessary for 1968.”
Studies demonstrate mixed results of the effectiveness of the 1968 tax charge, but it is possible other forms of fiscal policy can generate meaningful results in inflation. After all, they passed trillions in relief following the onset of the pandemic and passed the torch to the Fed to fix. For Keynesians, there is a simple approach – reduce liquidity from both fiscal and monetary angles. Alternatively, the tightening cycle of 1988 to 1989 was followed by a recession caused by the Iraq-Kuwait invasion.
This Time is Different BUT…
As the saying goes, history does not repeat itself, but it rhymes. The Fed can only do so much and should only do so much. The perfect storm of supply shocks, fiscal policy, and war have driven prices to levels not experienced by most. With reverting data points and more sustainable rates of change, it is possible the Fed makes it out of this tightening cycle alive. Jerome Powell’s moment of inertia is small and shrinking; an over-rotation could be a costly policy mistake. Then again, as the other saying goes, it all happens slowly then all at once. When you are reading headlines – ask yourself. Why am I reading this now?
Perhaps, this is not even the Fed’s fight. Numerous sectors (travel, leisure, etc.) have demand below 2019 levels. Statista conducted a survey to understand reasons why consumers did not plan a trip. 45% of US respondents and 41% of EU respondents attributed to affordability. The underlying supply and demand characteristics within the energy sector are quite gruesome with no solution in sight.
US Gasoline Inventories
Perhaps, this is not the Fed’s fight…