HARD VS SOFT LANDING

1. Context 

2. U.S. inflation, unemployment

• The Consumer inflation numbers for the US, are based on the personal consumption expenditures (PCE) price index prepared by the Bureau of Economic Analysis.
• The overall PCE price index for January was 5.4 per cent higher than its level in the same month of 2022.
  Core PCE inflation, which excludes changes in consumer energy and food prices that tend to be more volatile, stood at 4.7 per cent year-on-year.
• Both "general and core" inflation has been ruling well above the US Federal Reserve's target of 2 per cent.
• While the former has fallen from its June high of 7 per cent, the latter, considered a more accurate gauge of the underlying inflationary trend in the economy, has been stubbornly stuck at around 5 per cent (Chart 1).
• But more than year-on-year (Jan 2023 over Jan 2022), it's the month-on-month (Jan 2023 over Dec 2022) inflation that has been the shocker from the PCE price index data issued on February 24.
• The increase in prices over the prior month was 0.6 per cent translating into an annualized rate of 7. 2 per cent.
• Chart 2 shows this monthly rise was the highest for the general and August for the core index since May.
• The above data should be seen along with an earlier employment situation report of the US Bureau of Labour Statistics, released on February 3.
• It showed the total non-farm payroll employment surging by 5, 17, 000 in January against an average monthly gain of 4, 01, 000 in 2022 the most since the 5, 68, 000 in July.
• Moreover, the unemployment rate, at 3.4 per cent in January, fell to its lowest since May 1969.

Image Source: The Indian Express

3. Monetary policy implications

• The January inflation and employment data point to two things.
• First, inflation has returned after seemingly retreating towards end-2022, although even those numbers were way elevated vis-a-vis the US central bank's goal of keeping the annual PCE price index increase to 2 per cent.
• Second, falling unemployment, which reflects the demand for labour outstripping supply, has complicated the Fed's job.
• The labour market's tightening going out of balance is putting upward pressure on wages and in turn, driving up inflation.

4. US Federal Reserve's response

• Given its commitment to price stability and getting inflation back down to 2 per cent, it has no choice but to raise interest further.
• As credit becomes more expensive, businesses and consumers will hire and spend less.
• Economic activity slowing would then reduce overall demand, help coolly overheated labour markets and eventually bring inflation under control.

• Hiking further would risk what economists term a "Hard landing". When inflation is persistent at 5 per cent and the target is 2 per cent, interest rates will have to be increased high and fast enough and kept at those levels until economic activity moderates sufficiently.
• That would mean a sharp downturn or recession just ahead of the US presidential elections.
• It is the opposite of subdued growth or a mild recession (Soft landing), which follows the Fed having to raise rates only slowly and in small amounts to reduce inflation from, say 3 per cent and cool an economy not that overheated.
• An indicator of where interest rates are headed is provided by yields on 10-year US government bonds.
  Between February 2 (before the jobs report) and February 24, these basically what the government would pay for a 10-year loan have soared from 3. 40 per cents to 3.95 per cent.
• The markets are pricing in significant monetary tightening by the Fed in the coming days.

5. Layoffs and resignations

• One reason may have to do with jobs cuts happening more among skilled and better-paid employees, especially in tech companies that probably over-hired earlier.
• A second factor could be the US labour force shrinking relative to its working population (aged 16 and above). 
• That ratio called the labour force participation rate has fallen from 63. 1 per cent in 2019 to 62. 2 per cent in 2022.
• In other words, almost 1 per cent of working-age Americans, who were employed or looking for jobs prepandemic, have exited the labour force.
• Third, In a recent National Bureau of Economic Research paper estimated an average decline of 11 hours worked per person per year in the US between 2019 and 2022.
• The labour market is tightening not just because fewer Americans are working; even those working are choosing to work fewer hours.
• One of the pandemic's more permanent legacies has been the "Great Resignations' and Quiet Quitting".
• These are people opting to "recalibrate their work-life balance in the direction of fewer work hours".
• The various cash transfers and economic reliefs extended during the pandemic would also have enabled such reassessment of life priorities.

6. The situation in India

• The Reserve Bank of India (RBI) is facing a similar dilemma, with the declining consumer price index (CPI) inflation trend reversing in January.
• The central bank's mandate requires it to keep annual CPI inflation at 4 per cent.
• While this target is subject to an "upward tolerance limit" of 6 per cent making it less rigid than the US Fed's 2 per cent even though these levels were breached for both general and core inflation in the latest reported month (Chart 3).
• The greatest source of uncertainty for the RBI now is the impact of higher-than-normal temperatures on wheat and other rabi crops, due to harvesting from March-end.
  If temperatures spike further, as they did last March, it could reignite inflation in food.
• Also, a pick-up in rural wages appears underway, with the average year-on-year increase in rates exceeding CPI inflation since November.
• Like the Fed, the RBI, too, has hiked its benchmark repo lending rate from 4 per cent to 6.5 per cent since early May 2022.
• How much more it may hike to dampen demand and risk a "Hard landing would possibly be as much a function of electoral compulsions as of economics.

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