What Is a Soft Landing? Definition, Explanation & Example
When the Fed's efforts to curb inflation with higher interest rates are effective and don't result in a recession, the economy experiences what is known as a "soft landing."
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What Is a Soft Landing in Economics?
Statistics tell us that when it comes to flying, the most dangerous part is landing. As an airplane makes its final descent, much skill is required by the pilot to battle the wind, line up with the right runway, roll out the landing gear, and let the wheels safely touch the ground. Unlike at cruising altitudes, the pilot has less time to react to any problems since the airplane is approaching the ground and moving fast.
In finance, you might think of a “soft landing” as a way to tame inflationary pressures while avoiding a recession. Picture the example above in economic terms. Imagine that the pilot is the Federal Reserve and the airplane the U.S. economy. Interest rates are the landing gear—they must be steered correctly to ensure safety, all the while battling headwinds such as volatility, negative investor sentiment, and even capitulation.
Understanding the Economic Cycle
It’s important to remember that economic cycles contain periods of both expansion and contraction—they have to. If an economy was in a state of perpetual expansion, inflation would run rampant. Without contractions, assets would become overvalued, bubbles would form—and burst—and irrational selloffs would result. Growth and contraction, therefore, are natural parts of the economic cycle.
- Bull markets, which are defined as expansionary periods, average 5 years in length—at this time, there are more buyers than sellers, and the economic cycle has yet to peak.
- Bear markets, which are defined as periods of post-peak contraction, are when the stock market declines and assets lose value. These typically last an average of 2 years.
How can you tell which stage of the economic cycle we’re in? Analysts look at monthly data releases that demonstrate how all facets of the economy are performing, from industrial production to new-home sales, employment, consumer and producer prices, and GDP growth. Taken together, these data points are known as business cycle indicators. They consist of both leading indicators, which are forward looking, and lagging indicators, which are historical.
How Does a Leading Indicator Foretell Recession?
Take, for example, the yield curve, which is measured by the “spread” or difference between 2-Year and 10-Year Treasury securities. Normally, longer-term Treasuries have higher yields than shorter-term Treasuries because the bond issuer—the U.S. government—is incentivizing investors to lend them money over a longer timeframe.
When the curve inverts, or trends downward, shorter-term Treasuries—specifically the 2-Year Treasury—actually offer higher yields than the longer-term 10-year Treasury. Why would an investor take on more risk for less reward? They wouldn’t, and so the inversion illustrates waning confidence in both the U.S. economy—as well as the federal government. Stocks typically sink on the news, and pessimism takes center stage, often festering for quite some time.
How Are Soft Landings Engineered by the Federal Reserve?
There is no doubt the Federal Reserve exerts a powerful influence over the financial world. Their decisions, what they say in their policy statements—even what they don’t say—often moves markets.
So, for the Federal Reserve to fulfill its mandate to maintain a healthy economy through strong employment and stable prices, it has a few tools at its disposal, like increasing or decreasing the fed funds rate, which influences consumer interest rates, including car loan and mortgage rates.
When the Federal Reserve notices inflationary pressures, it usually attempts to find the “middle ground” by raising interest rates at a consistent but gradual pace that doesn’t completely kill off economic growth. By doing so, the Fed attempts to engineer a soft landing for the economy during times of market contraction.
Soft Landing vs. Hard Landing: What’s the Difference?
Recession is the key difference between a soft landing and a hard landing in the U.S. economy. Through a soft landing, the Fed is able to successfully steer the economy through the contractionary cycle while avoiding recession.
Hard landings are much bumpier. Perhaps inflation gets out of hand and takes years to wrangle, or the Fed must deal with additional crises, like a supply shock, such as the OPEC embargo of oil imports into the U.S. in the 1970s, undercutting their management efforts and resulting in miserable, years-long recessions.
Example of a Soft Landing
Alan Greenspan is widely credited for engineering a soft landing for the U.S. economy during 1994 and 1995. The then-Fed Chairman raised interest rates from 3.1% to 6% without the economy falling into recession. A five-year bull market would follow, fueled in large part by the rise of fledgling Internet IPOs, only to be toppled by the implosion of the Dot-Com Bubble of the early 2000s.
Example of a Hard Landing
An unfortunate example of a hard landing could be seen after the Fed raised interest rates from 1.0% to 5.25% at the onset of the Financial Crisis, causing millions of subprime homeowners who had adjustable-rate mortgages to default on their loans. The U.S. economy nose-dived into the biggest recession since the Great Depression: The Great Recession.
Will There Be a Soft Landing in 2022?
TheStreet.com’s Dan Weil thinks there is a “narrow path” to a soft landing in 2022—find out what it is here.