COLUMN-Fed searches for elusive soft landing: Kemp

U.S. manufacturers are reporting a slower rate of expansion as the sector struggles with the combined impact of supply chain problems and rising input prices.

The Institute for Supply Management’s purchasing managers’ index dipped to 57.6 in January from 58.8 in December and a peak of 63.7 last March. The composite index is now in the 85th percentile for all months since 1980, down from the 89th percentile in December and 99th percentile last March (https://tmsnrt.rs/3AP2fx0).

The index is still well above the 50-point threshold that divides expanding activity from a contraction, but increases in activity are less widespread than before. The new orders, production, inventories, and supplier deliveries components all showed slower growth last month. Only jobs accelerated.

The drop in the index is normal at this point in the cycle as the very rapid increases of the first phase of recovery, associated with the restart of previously idle capacity, give way to a more moderate expansion. In this second phase of the upturn, activity increases are usually concentrated in a narrower set of businesses as pressure on costs, labor shortages and overstocking become more problematic.

As in previous cycles, inflationary pressures are likely to continue to intensify, even as manufacturing growth moderates, because the number of binding capacity constraints on short-term production will multiply. RATES LIFT OFF

Policymakers at the U.S. Federal Reserve have already signaled their intention to end the bond-buying program and begin raising interest rates to reduce its economic stimulus. Rate traders expect the central bank to lift its federal fund's target by almost 125 basis points by January 2023 as it attempts to bring inflation under control.

The critical question is whether the Fed can engineer a soft-landing, reducing inflation to its target of a little more than 2% from its current rate of 7% without pushing the economy into recession. However, soft landings have previously proved hard to achieve.

Since 1918 consumer price inflation has subsided from a peak of more than 5% on 10 occasions, but on six of them, the reduction was associated with a recession. On each of the past five occasions when inflation peaked above 5% - in 1970, 1974, 1980, 1990, and 2008 - it was followed by recession.

The most recent occasion when inflation subsided without an immediate recession was in 1951, with the economy overheating as a result of the Korean War, and before that, in 1947 as the economy emerged from the Second World War. Some policymakers and economists have argued that the emergence from the COVID-19 pandemic is more like a postwar demobilization and conversion to the civilian industry than a normal business cycle.

White House economists have compared the current picture to the rapid increases in 1947, caused by the end of price controls in conjunction with supply chain problems and pent up demand after the war (“Historical Parallels to Today’s Inflationary Episode”, Council of Economic Advisers, July 6, 2021). The problem with this analogy is that it is only one instance from more than 70 years ago. More recent and more frequent inflation episodes have generally been ended by a recession or a mid-cycle slowdown.

Price pressures have an internal momentum of their own and tend to intensify rather than lessen as the business cycle becomes more mature and the margin of spare capacity shrinks in all markets. The Fed may yet be able to defy the odds and engineer a soft economic landing without a recession or a serious mid-cycle slowdown, but top policymakers throughout the past 70 years have failed more often than they have succeeded with that goal.

History suggests that the required policy path for a soft landing is exceedingly narrow and often impossible to navigate. Related columns:

- Commodity prices likely to be hit by slowdown before end of 2023 (Reuters, Jan. 27) - Escalating U.S. inflation forces macro policy rethink (Reuters, Jan. 13)

- Global economy faces the biggest headwind from inflation (Reuters, Oct. 14) John Kemp is a Reuters market analyst. The views expressed are his own 

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