US and Europe heading towards the coveted ‘soft landing’ with resilient economies
Despite sharp interest rate hikes, both are defying the gloomy forecasts of many economic analysts
In the years following the historic 2008 financial crisis, the IMF, the OECD and other major international organizations became overly optimistic. Year after year, reality tested growth forecasts that repeatedly proved to be too bullish. This trend has seen a reversal recently. The energy crisis triggered by Russia’s invasion of Ukraine dampened European growth, starting with Germany, but it didn’t cripple the bloc as feared. But caution is always warranted in the forecasting business, as the economy is an ever-evolving story — the last few years have proven that anything is possible. Macroeconomic indicators show remarkable resilience despite the steepest interest rate hikes in four decades.
Pessimistic economists dismissed the prospect of a soft landing last year, the coveted scenario in which an economy can digest inflation and rising interest rates without sinking into a deep recession. Now, what was once a niche theory is close to becoming a tangible reality. Growth is slowing on both sides of the Atlantic, but it hasn’t stopped altogether. This is mainly due to a strong labor market and steady household consumption in the face of significant credit tightening.
If one had to choose a single word to describe the economy in 2023, it would undoubtedly be resilience. Inflation is approaching reasonable levels again, and with the prospect of interest rate cuts by the Federal Reserve and the European Central Bank (ECB), a much more favorable economic outlook is not unthinkable. The future is not all rosy, but it is far from the “blood, sweat and tears” that many feared.
“Everything is pointing towards a soft landing, as proven by the recent stock market surge,” said Xosé Carlos Arias, an economics professor at the University of Vigo (Spain). “The feeling is that we are converging towards the 2% inflation target, so fears of price spikes are dissipating.” However, everything is still in the treacherous realm of “it seems as if…” Still, Arias said, “One thing is clear: tight monetary policy has not led to a severe recession, and any comparison to the [oil] crisis of the 1970s is hyperbole.”
Mitigating factors
“We may still see a quarter with stagnation or a slight decline, especially in the U.S., but not the major recession that was feared,” said Leopoldo Torralba of Arcano Research, an economic research firm that has been remarkably accurate with its recent forecasts. “History shows that high interest rates often precede recessions. However, this crisis is unique. Unlike previous episodes, there were no significant imbalances this time, and several buffers helped mitigate the shock.”
These buffers can be summarized as three main mitigating factors: household savings that enabled many families to maintain consumption levels; reasonable levels of private debt (households and businesses) that avoided a financial implosion like the one in 2008; and a greatly improved banking system that was well-prepared to handle defaults.
“It hasn’t been a demand crisis, but rather a supply crisis, with factors that we believe will self-correct,” said Torralba. Looking ahead, this economist predicts that household purchasing power will increase “earlier than expected, as inflation continues to normalize,” along with the interest rate cuts in the U.S. and the eurozone starting in the second or third quarters. Torralba says this should lead to steady demand, which will sustain the economy.
The Fed avoids declaring victory
In his memoirs, former Federal Reserve Chairman Alan Greenspan (1987-2006), highlighted one of his major achievements: successfully achieving a soft landing through interest rate hikes in 1994. It was the first time ‘soft landing’ — a term that came out of the U.S.-Soviet space race in the 1970s — had been used at the Fed. Current Fed Chairman Jerome Powell has been striving to emulate Greenspan’s 1994 example for the last 18 months.
After several months of persistent recession predictions with timelines that were continually pushed back, Powell began to taste success in late 2023. He stressed that inflation in the U.S. decreased without a substantial rise in unemployment, which remains below 4%. The Federal Reserve’s monetary policy committee now projects a favorable scenario for 2024: a 1.4% growth rate; a 4.1% unemployment rate; and inflation nearing the 2% target.
However, Powell and his Fed colleagues remain cautious about declaring victory. In a recent speech, Tom Barkin, President of the Richmond Federal Reserve, stretched the airplane metaphor when he said, “A soft landing is increasingly conceivable but in no way inevitable. I see four risks. The U.S. economy could run out of fuel. We could experience unexpected turbulence. Inflation could level off at a cruising altitude higher than our 2% target. And the landing could be delayed as the U.S. economy continues to defy expectations.”
Running out of fuel, turbulence and landing at the wrong airport
When Barkin talks about running out of fuel, he means the delayed effects of monetary tightening impacting the economy, as well as the reduced demand caused by the depletion of household savings accumulated during the pandemic. Turbulence can be geopolitical and financial shocks, or something else altogether. Thinking that it’s fine to land at 3% inflation — the wrong airport — would be a mistake, says Barkin.
In both the U.S. and Europe, critics have increasingly decried the rapid increase in interest rates. Some argue that the pace may have been too fast, considering the underlying factors that drive inflation. ECB President Christine Lagarde defended its rate-hike program, saying the latest inflation data for the eurozone is positive and in line with expectations. Eurozone inflation in December ended up at 2.9%, slightly higher than in November, but still below analysts’ expectations and a far cry from the peak of the crisis.
“The airport is on the horizon. But landing a plane isn’t easy, especially when the outlook is foggy, and headwinds and tailwinds can affect your course. It’s easy to oversteer and do too much or understeer and do too little” said Barkin. “And there’s no autopilot.”
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