Hard or soft landings?

A worker hoists a flight chain at the Calder Brothers’ facility in Taylors, South Carolina, U.S

We’ve tended to err to the idea that they are more likely to be soft than hard and the BIS’s annual outlook which was just released helps us put some more colour to this story.

Soft landings are presumed to be difficult to achieve with lots of focus on the fact that the FED, for instance, has only rarely achieved such an outcome. However, BIS research suggests that it might not be so unusual to achieve a soft landing when looked across a range of countries. It looked at 35 countries in the period from 1985 to 2018 which included 129 tightening cycles.

It found that about a half of these led to hard landings, as defined as a recession within three years of the interest rate peak. Of course, many people could question this definition of a hard landing but think it is reasonable. Importantly, the BIS notes the common characteristics of economies before they enter the hard landing scenario. None of these are very surprising.

For instance, economies are more likely to undergo a hard landing if there are financial vulnerabilities at the start of the cycle, often generated by low real rates and fast credit growth (think the global financial crisis of 2008). Tightening cycles that start when inflation is very high are more likely to lead to hard landings and, while the extent and speed of the tightening cycle is not necessarily a key factor, the BIS finds that longer tightening cycles more often lead to hard landings.

Armed with these findings, how does the global economy seem to stack up at the moment? In Mr. Steve Barrow, Head of Standard Bank G10 Strateg’s view, the question about financial vulnerability is a hard one to answer. Asset prices were very high coming into this cycle across both financial assets and real assets such as housing. But the backdrop of the global financial crisis has made banks safer with credit vulnerability seemingly better managed. This being said, one cost of better banking safety could be greater vulnerability in the non-bank or shadow banking sector. This could prove to be the world’s Achilles heel.

“But while we have seen some instances of vulnerability, such as the demise of Greensill, our sense is that if this sector is vulnerable, we would have seen much more tumult before now. Of course, real interest rates were very low before the tightening cycle and the cycle has started at a time when actual inflation is very high indeed; two attributes that would seem to send out hard-landing messages as far as the BIS data would suggest”, stated Mr. Steve Barrow.

On the flip side, market expectations seem to be for a short tightening cycle with FED rates, for instance, generally seen falling very slightly next year. Indeed, it certainly seems that many central banks are singing from the BIS’s song-sheet and lifting rates aggressively and quickly. If the BIS’s analysis proves correct though, central banks like the FED will have to get rates down again quickly to avoid a hard landing.

Finally, it is noted that, in using historical data to determine the likelihood of hard landings, nothing is ever the same as the past, and perhaps particularly not know. One reason for this is that the global downturn emanates from a supply shock and not a demand shock.

Mr. Steve Barrow said the above fact makes it more difficult to avoid a hard landing because policymakers have next-to-no control over supply shocks. On a more positive note, central bank credibility is better than it was, thanks to decades of low inflation. In addition, as mentioned earlier, there’s more use made of macroprudential tools than in the past which may mean that rate hikes are not quite the blunt instrument to bash demand on the head that they once were. But even when we take these positives into account, avoiding a hard landing is still going to be tricky.

“We think it all comes down to whether asset prices fall moderately as they have been doing, or accelerate to the downside uncontrollably. We err to the former, and hence see soft landings, but are always watching out for the latter”, said Mr. Steve Barrow.