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What Are the Necessary Ingredients for a Soft Landing?

Historically, large monetary policy tightening episodes akin to the one we've witnessed over the last year have rarely marked the beginning of a sustained expansion. In a sample of 140 hiking cycles across the last 70 years of developed market history, a recession has followed a rate-hiking cycle 75% of the time – and this figure goes up if you look only at hiking cycles characterized by elevated inflation at the start of the cycle.

Nevertheless, many economists and central bankers suggest a "soft landing" continues to be the most likely case for the global economy. Some recent data have been encouraging, and our analysis suggests that a soft landing is possible. However, we believe both historical precedent and present circumstances suggest a mild recession in the next few years is, unfortunately, more probable.

Stylized facts from historical hiking cycles
After analyzing more than 140 hiking cycles in 14 developed market (DM) economies over last 70 years, we can characterize the economic performance of the average hiking cycle and group hiking cycles by various traits. Several stylized facts (i.e., general takeaways from empirical findings) emerge:

• Historically, these DM economies tended to weaken around 6 to 8 quarters after the start of a rate-hiking cycle, with a recession starting, on average, 2 years out.
• The weakening tended to be led by investment spending and bank credit, which also tended to deteriorate around 6 to 8 quarters after the start of a cycle. Consumption also slowed, but more gradually.
• During hiking cycles characterized by elevated inflation (for our analysis we define "elevated" as core inflation above 4% annualized at the start of the rate-hiking cycle), the central banks tended to hike rates higher and faster and kept rates elevated for longer. Not surprisingly, in these circumstances economies tended to weaken sooner – 2 to 4 quarters after the start of the cycle – and to experience a much higher rate of recession (90% of cycles) over the ensuing 4 years.
• Soft landings (defined in this analysis as economic expansions that continued for more than 4 years after the start of a hiking cycle) when inflation was high at the start of a cycle have been exceedingly rare. In fact, in our sample, there were only 7 instances (out of more than 140 hiking cycles) across various DM economies. These were all clustered in the early to mid-1980s, when the negative oil price shock from a surge in OPEC production allowed central banks to quickly cut rates after hiking them.

Compare this with today
Comparing the current rate-hiking cycle with these historical experiences, a few more stylized facts emerge. So far, economic activity across developed markets is tracking much stronger, with consumption – and U.S. consumption in particular – being the standout category. (Read more in our 23 August 2023 edition of Macro Signposts .) Resilient consumption is in turn likely related to the drawing down of lofty excess savings accumulated from pandemic-era fiscal stimulus and, in the U.S., the relative insensitivity of debt service ratios as a result of a large stock of low-fixed-interest-rate mortgages. A tight labor market and moderating inflation have also supported real household incomes.

The historical ingredients of a soft landing
However, resilient consumption isn't a consistent hallmark of prior economic soft landings. In fact, periods of resilient consumption that fuel continued inflationary pressures and more rate hikes usually have ended in recession.

So what traits have historically characterized soft landings? We see three.

First, and we would argue most importantly, you need a positive supply-side shock. Trade liberalizations and productivity booms that coincide with rate-hiking cycles are a feature of soft landings historically. In our sample, there were three instances where DM economies were able to achieve soft landings:

• Mid-1960s: After the early 1960s saw international trade accelerate with the decline in trade barriers and tariffs through the proliferation of the General Agreement on Tariffs and Trade (GATT) system, DM economies managed a soft landing.
• Mid-1980s: This period included a significant negative oil price shock, as OPEC accelerated production in an attempt to regain market share, which led to a surplus in the global oil market.
• 1990s: In addition to another trade boom, with the inclusion of China in the World Trade Organization (WTO), the late 1990s saw elevated productivity growth related to the widespread adoption of information technology (personal computers, the internet, and various business software applications).

The second ingredient for a soft landing is if peak inflation occurs at or near the start of the hiking cycle. In the 1960s and 1980s episodes, inflation accelerated before the hiking cycle only to peak at or soon after the start. In the 1990s, inflation peaked in the U.S. in the early part of the decade, then decelerated through the rest of the period.

Moderating inflation helps enable the third ingredient of a historical soft landing: a central bank that quickly reverses course to cut rates. Within our soft-landing sample, on average the central bank hiked around 250 basis points (bps), and then cut rates by a similar amount within a year or two. That compares with the hard-landing sample with over 500 bps of hikes on average and later cuts that left rates higher than they were before the cycle started.

Macro implications for the current cycle
A soft landing is certainly possible, but in our view, recession risks are still elevated. Supply improvement after the pandemic should continue to moderate inflation, but tight labor markets and sticky wages could very well apply inflationary pressure absent a productivity boom. Supply expansions from rising global trade look unlikely now (if anything, globalization is likely moving in the opposite direction given the West's geopolitical tensions with China). Advances in artificial intelligence could accelerate productivity; however, how quickly these technologies can become macro-significant is uncertain.

In this environment, it's not clear to us that the Federal Reserve would quickly cut rates as headline inflation slows. Although rhetoric around the need for further hikes has softened recently as central banks have moved policy into restrictive territory, many policymakers have emphasized "significant" inflation risks as a reason to keep rates restrictive for a prolonged period.

Of course, it's yet to be seen what central banks actually do in the future. However, a prolonged period of tight policy has historically very rarely (if ever) ended in anything other than rising unemployment and economic contraction.

This report, like future reports, summarizes the vast array of data analysis that we do at PIMCO. Please don't hesitate to ask us about the underlying data and analysis. If you would like to reach out, please email [email protected].

For regular insights on U.S. policy via email, please write to [email protected] and ask to receive the Washington Watch.

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