Why a Soft Landing Could Prove Elusive

Similarly, this summer’s combination of easing inflation and a cooling labor market has fueled optimism among economists and Federal Reserve officials that this elusive goal might be in reach.

But soft landings are rare for a reason: They are tricky to pull off. “You need a lot of luck," said Antúlio Bomfim, a former adviser to Fed Chair Jerome Powell who is now at Northern Trust Asset Management.

Fed officials are set to hold rates steady this week after raising them to a 22-year high because they don’t want to blow a shot at achieving a soft landing.

The goal faces four threats: the Fed holds rates too high for too long, economic growth accelerates, energy prices rise or a financial crisis erupts.

“The Fed could temporarily achieve a soft landing, but I’m skeptical that it could stick the landing for very long," said Peter Berezin, chief global strategist at BCA Research in Montreal.

Once the economy is operating with little or no slack, anything that boosts demand could stoke inflation. Meanwhile, anything that lowers demand could send the unemployment rate rising, a process that is hard to stop once it starts, said Berezin. He expects a recession in the second half of next year.

The 1969 moon landing propelled the “soft landing" expression into the economic lingo in the early 1970s. Nixon administration officials sought to conquer high inflation without triggering a severe downturn.

Since World War II, economists say, the U.S. has achieved only one durable soft landing, in 1995. “We steered the economy very expertly, but in addition, we were lucky. Nothing bad happened," said Alan Blinder, an economist who was Fed vice chair from 1994-96.

Here is what could go wrong this time.

The Fed stays too tight

First, if the Fed holds rates too high for too long, it would risk an unnecessarily severe downturn. The 1995 soft landing occurred after Fed officials pivoted quickly to cutting rates. After doubling their benchmark federal-funds rate to 6% over the 12 months through February of that year, they realized they might have acted too aggressively. Growth faltered and global forces appeared to be tamping down price pressures. They reduced rates three times starting in July.

Back then, inflation was around 2% and Fed officials were lifting rates to prevent it from rising. Today, with inflation above 3%, they are trying to force it down. Officials have indicated they will hold rates at high levels for longer than they might have before the recent inflation spell to ensure price pressures don’t resurge.

After Fed officials stop lifting rates, Berezin said, “my worry is that they’ll stay on ‘pause’ longer than they need to because it will be embarrassing to start cutting rates so soon after" raising them and because they might fear repeating their mistake of underestimating inflation risks two years ago.

In addition, avoiding a recession if inflation is tamed will eventually require keeping interest rates close to their so-called neutral level that neither spurs nor slows growth. Because this rate can’t be observed, it is hard to identify.

The economy stays too hot

Second, consumer spending and business activity are showing signs of accelerating again after slowing last year. If that continues, Fed officials could conclude that inflation’s decline risks stalling out unless they raise rates higher, increasing the chances of a recession.

The Fed lifts rates to fight inflation by slowing economic activity. That occurs, partly, as higher borrowing costs and lower asset prices lead executives to spend and hire less. But the economy has proven surprisingly resilient so far to the Fed’s aggressive moves, offering fewer signs that companies are taking such steps.

The economy over the coming years could be buoyed by higher savings and income unleashed by the heavy stimulus that governments deployed to ease the pandemic’s fallout, said Steven Blitz, chief U.S. economist at GlobalData TS Lombard.

“If I’m sitting at the Fed, what bothers me most is I am seeing nonfinancial corporate earnings increase in the second quarter, and the stock market is not showing me any sign that investors expect earnings to be falling this quarter," said Blitz. “If earnings are going up, employment is not going to get weaker."

He expects Fed officials to discover next year that they have either raised rates higher than necessary or not lifted them high enough. That leaves little room for a soft landing. “Planes land. Economies don’t. They are in a constant, dynamic process that is ongoing," Blitz said.

Energy prices take off

Third, rising oil prices threaten to drive inflation higher while reducing growth by slowing discretionary spending. Such a “stagflationary" shock “is the opposite of what you want if you’re trying to engineer a soft landing," said Blinder.

Production cuts by the Organization of the Petroleum Exporting Countries and its allies have lifted crude-oil prices to 10-month highs and boosted the premiums refiners can charge producing the heavy fuels that power trucks, planes and ships. Rising diesel-, jet- and marine-fuel prices could reverse recent declines in inflation driven by lower transportation costs and push up prices on everything from food to construction.

Oil-price spikes after the Fed started cutting rates in 1990 and 2008 contributed to much harder landings. Benchmark U.S. crude-oil futures prices closed at roughly $91 a barrel on Friday, up nearly 30% since June. “I don’t think we’re quite there yet, but if oil prices were to go above $100 again, I would certainly start to get more worried," said Berezin.

In past episodes, the Fed hasn’t raised rates when facing a one-time supply hit that lifts prices. But after 2½ years of high inflation, officials have reason to fear a new price shock would spur inflation. Officials say consumers’ and businesses’ expectations of future inflation play a critical role in determining actual inflation. Higher gasoline prices threaten to drive up those expectations, which have been remarkably stable.

A financial-market mishap

Fourth, the economy could be hit by some market crackup or geopolitical crisis. Many analysts see the rapid adjustment in global borrowing costs and the lagging effects of past increases as a source of instability.

The Fed held interest rates near zero for seven years after the 2008-09 financial crisis and lifted them to still-historically-low levels in the years before the pandemic brought rates back to zero. As a result, some financial firms and businesses might have made investments or plans that counted on rates staying much lower for longer.

A further half-percentage-point increase in interest rates would put greater strain on the banking and property sector, said JPMorgan Chase Chief Executive Jamie Dimon at a conference last week.

He warned of risks posed by large, widening U.S. budget deficits that have to be financed by investors at the same time the Fed is shrinking its $8.1 trillion asset portfolio of government securities. Both of these could test the ability of financial markets to digest ever-larger supplies of Treasurys, which influence interest rates on home mortgages and business debt, without bigger increases in yields.

“There’s a false sense of security that those two things will end up being OK," said Dimon. “To say, ‘The consumer is strong today,’ meaning you [will] have a booming environment for years, is a huge mistake."

Write to Nick Timiraos at Nick.Timiraos@wsj.com