📈 Can AI prevent a US recession?

Business enthusiasm and investment might be the extra bit of help the Federal Reserve needs to pull off a 'soft landing'

Quote of the Issue

“Prosperity on a national scale—mass flourishing—comes from broad involvement of people in the processes of innovation: the conception, development, and spread of new methods and products—indigenous innovation down to the grassroots.” - Edmund Phelps, Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change

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The Essay

📈 Can AI prevent a US recession?

Even without a deep dive into the current economic data, there’s good reason to think the American economy won't avoid slipping into recession over the next year or so: history. The Federal Reserve has raised the federal funds target rate by 525 basis points (or five and a quarter percentage points) over the past 17 months. Those rate hikes represent the fastest tightening cycle in four decades, with the fed funds rate now at its highest level since January 2001.

Given that track record, those folks who are beting on a "soft landing" — a scenario where a savvy tightening of monetary policy to fight inflation lays the groundwork for a continued post-pandemic economic expansion — have to confront the historical record of soft-landing rarity. The odds just aren’t good.

In a recent report, JPMorgan economists Bruce Kasman and Joseph Lupton note there are just three episodes over the past 60 years in which a Fed tightening of 250 basis points or more was followed by three or more years of US economic expansion. From the report:

The Fed raised policy rates by more than 250bp during 1964-66, 1983-84, and 1994-95. The 1960s expansion lasted three years beyond Fed tightening, while the 1980s and 1990s episodes saw expansions extend for more than five years. Given the terms of the current debate, the most interesting feature of these soft-landing episodes is labor market performance. None of these episodes generated labor market slack or reduced wage pressures. Notably, the US unemployment rate continued to move lower and hourly compensation for the non-farm business sector (NFB) moved higher in the two years following the end of Fed tightening.  

It would be awesome if unemployment could stay low and real wage growth strong even as inflation continued to decline to the level the Fed wants. And if that’s going to be the case this time around, it’s worthwhile taking a look at that 1990s example of a Fed-engineered soft landing. Back then, the Fed raised rates seven times in 13 months to cool the economy. The US economy had started recovering strongly after a brief but nasty downturn to kick off the decade. Aided by some powerful tailwinds, including Baby Boomers reaching peak earnings and strong immigration, the economy grew at 3.5 percent in 1992, 2.8 percent in 1993, and 4.0 percent in 1994.

But with inflation running hot, the Fed acted. “The decision was taken to move toward a less accommodative stance in monetary policy in order to sustain and enhance the economic expansion,” read the FOMC statement accompanying the February 1994 start of the tightening cycle.

What followed was a great Fed success. Core PCE inflation downshifted to below 2 percent in the year after the 1994-95 tightening and stayed low throughout the remainder of the 1990s expansion. Meanwhile, the jobless rate fell from 6.6 percent in February 1994 at the first hike to 5.6 percent in February 1995 at the last — and then kept on falling even as the economy roared. The notion of Fed boss Alan Greenspan as a “monetary maestro” was born.

What soft landings have in common

In each of the three successful soft landings, the JPM economists note, including the 1990s one, the Fed quickly reversed course and started cutting, which helped avoid a hard landing. Also important: Each soft landing saw the emergence of a “growth impulse,” as Kasman and Lupton put it. From the report:

Between 1965-68, US government spending as a share of GDP rose 3.5%-pts as expanding social benefits and the escalation of the Vietnam war provided a large demand impulse. In the mid-1980s, the economy also received a boost from strong government spending. Improving external conditions were also a major growth catalyst in the second half of the decade. A collapse in global oil prices dramatically lowered headline inflation over 1985-86, a terms-of-trade lift followed by a sharp acceleration in European and Japanese growth that produced a surge in US exports. Neither fiscal policy nor the external backdrop was favorable following the 1994- 95 Fed tightening. But a tech-led investment spending boom, accompanied a sharp acceleration in productivity growth, fueled growth in the second half of the 1990s. … The 1990s US experience — in which a supply-side boost to both productivity and labor supply fueled growth — would seem to provide the best recipe for a soft-landing outcome. Indeed, the mid-1990s saw further margin expansion in the aftermath of Fed tightening alongside firming wages, strong growth and stable inflation.

I think you see where JPM and I are going here: