Can the Fed Downshift Smoothly?

When the central bank has raised interest rates to fight inflation, a recession has often resulted. Analysts differ about its odds this time.

By Nicholas Riccardi
Times Staff Writer

April 27, 2005

It's called a soft landing — when the Federal Reserve tames inflation and tempers an overheating economy's growth by raising interest rates.

It's not easy.

The problem is that when the Fed boosts interest rates, as it has been doing steadily since June, it usually sends the economy into a crash landing. Virtually all recessions since World War II have been preceded by Fed interest rate hikes.

With fresh signs in recent weeks that economic growth is slowing while inflation is heating up, analysts are debating whether the U.S. economy could be gearing up for a repeat performance. Some economists contend that the Fed has less control over the economy this time around, partly because of bulging trade and budget deficits as well as China's growing economic and financial clout.

"I think we're very, very vulnerable now," said Dean Baker, co-director of the Center for Economic and Policy Research in Washington. "The record on engineering soft landings isn't terribly good."

Others think that the Fed just might pull off the soft landing, because the central bank is starting from a better location than it has in the past. Interest rates are still far lower than they were in the last three decades. The central bank, having no intention of causing a recession, could stop raising rates before the hikes trigger a severe downturn, the optimists argue.

"Frequently, the Fed wanted to cause a recession in order to bring down inflation," said Alan Blinder, a former vice chairman of the Fed who teaches at Princeton University. "That's not the case now."

There are many factors other than high interest rates that can cause a recession — a contraction of the economy — including chronic unemployment and oil shocks. But economists for years have debated how best to pull off the tricky balancing act between inflation and economic growth.

Analysts generally agree that the Fed must try to keep inflation from getting out of hand. Created in the early 20th century to regulate the nation's money supply, the Fed combats inflation by keeping the economy from overheating. The theory is that if it grows too quickly, prices begin to skyrocket and inflation ends up pushing down consumers' standards of living.

The Fed's chief tool in this mission is its ability to raise interest rates. In the best-case scenario, higher interest rates curb rising prices and take the edge off an expanding economy without destroying it. In the worst-case scenario, higher borrowing costs sock consumer and business spending, sending the expansion into a tailspin that could end in a recession.

Many analysts believe that Fed Chairman Alan Greenspan — in the last year of his 18-year tenure — has enough skill to do the job. After all, he helped engineer what economists often cite as the only successful soft landing in Fed history — a three-point interest rate jump in the mid-1990s that, rather than killing the economy, may have helped lay the foundation for the late-'90s boom.

But other efforts were not so successful. The 2001 recession was preceded by the dot-com bust, which some critics complain was sparked by Fed rate hikes in 2000. Fed hikes in the late 1980s helped trigger the downturn of the early 1990s. And in the 1970s, the Fed launched interest rates into the financial stratosphere to bring down runaway inflation, regularly threatening to derail economic growth.

In its latest round of tightening, the Fed has raised its benchmark short-term interest rate seven times since June, each time by a quarter percentage point, to the current level of 2.75%. Meanwhile, inflation has steadily crept higher, from 1.7% in the 12 months that ended in June to 3.1% today.

And after watching the economy expand at a sizzling 4.4% rate last year, Wall Street has recently been rattled by signs of slowing growth. The last month has seen drops in consumer confidence, slower retail sales and a ballooning trade deficit. The Fed meets again on interest rates next week.

The difficulty, analysts agree, is that the Fed has little control over many of the factors that determine whether its rate hikes actually work as intended.

"It's like landing a plane in somewhat turbulent weather," Blinder said. "If the weather cooperates [and] you don't get hit by any updrafts or downdrafts, you can get it in. But the best pilot, if he gets hit by a bad downdraft, he'll hit the runway hard. You need skill and luck."

One such potential downdraft is the growing influence of foreign nations, particularly China.

"I'm inclined to think it's the Chinese that have more control than Alan Greenspan," said Edward Leamer, director of UCLA's Anderson Forecast.

Specifically, Leamer pointed to an economic quirk that Greenspan has termed a "conundrum" — that despite Fed boosts in short-term interest rates, long-term rates have remained low. In the past, the long-term rates would respond to the Fed's short-term rate hikes, and curb economic expansion. Long-term rates are important because they directly influence mortgage rates and other consumer and business loans.

But now, Leamer and some other analysts theorize, there are other players in the global economy who do not want the U.S. economy to slow — mainly the Japanese, Chinese and South Koreans. They want American consumers to feel rich enough to continue to buy Asian-made goods. Under this interpretation, the central banks of those countries are buying U.S. Treasury securities, leaving long-term interest rates low despite the Fed's desires.

As evidence of this, the widely followed Grant's Interest Rate Observer newsletter reported this week that foreign banks had increased their holdings of U.S. debt securities by 63% since 2003 and now hold far more than what the Fed itself holds.

Some fear that the increased involvement of foreign central banks means that the U.S. economy is vulnerable to shocks if those countries decide to reduce their buying of American debt instruments. Such a move could push interest rates higher.

There is another potential downside. As the Fed loses control over long-term rates, it also becomes harder for the central bank to pop possible speculative bubbles in real estate and other assets. Many observers believe those possible bubbles pose the greatest risk to the U.S. economy.

"If you hammer interest rates down as the Fed did, what you get is a lot of speculation in real estate, a lot of speculation in the financial region," said James Grant, editor of Grant's Interest Rate Observer in New York. "That gives the economy a rush, but it's more of a sugar rush than anything more substantial."

The fact that analysts are worrying about the small increases in interest rates is, to Grant, a sign of larger problems.

"If the economy were not lopsided, if it were in balance," he said, a 2.75% rate "would not be viewed as a clear and present danger to prosperity."

Others, however, are more optimistic.

Anthony Chan, a former economist with the Federal Reserve Bank of New York, compares this to treating cancer with agonizing, but necessary, chemotherapy.

"The doctor knows if you have too much chemotherapy you're going to lose your hair, almost die, but the doctor says, 'We've got to do it or we're going to lose the patient,' " said Chan, who is now a senior economist with J.P. Morgan Asset Management.

Chan on Monday released a study that found that two out of three times since 1958, when the Fed raised interest rates, the economy went into recession within two years. But he thinks that this time the result will be different.

"Over time the Federal Reserve has learned, I think, a thing or two about how to control the economic expansion," Chan said. He pointed out that inflation is still far from the double-digit rates of the late 1970s that required stiff interest rate hikes.

And because the Fed's increases have been so small and gradual, many observers argue that the central bank runs less risk of damaging the economy this time out.

"In no way can you say the Fed is slamming on the brakes like they have in the past," said David M. Jones, a longtime Fed watcher and president of DMJ Advisors in Denver. "They've taken their foot off the accelerator, but they haven't slammed on the brakes."

Because of that, Jones concludes, "they have a chance of pulling off something like a soft landing."