Did the Fed engineer a soft landing?

It is the last Fed Day of the year, and this is going to be my last serious post of the year before tomorrow’s Christmas edition. And at the end of a year when inflation seems to have been tamed (at least for now) and the Fed seems to have engineered a proper soft landing (at least for now), I want to look at research that examines if the Fed really was responsible for lowering inflation and engineering a soft landing. After all, many people are giving the Fed credit for doing that and I, for one, am really surprised how well the Fed has managed this inflation bout. I didn’t think they would do so well two and a half years ago.

So first, my apologies to Jerome Powell for being overly critical of him, but then again, maybe he and his colleagues don’t deserve all the praise they get.

Thomas Ferguson from UMass Boston and Servaas Strom from TU Delft used a range of economic models to estimate how much of the drop in core PCE (the Fed’s favourite inflation measure) has been due to the rate hikes and how much has been just a natural decline as energy prices receded and demand slowed.

As the chart below shows, the Fed can claim to have reduced core inflation by a cumulative two percentage points from mid-2022 to mid-2024. That is a lot because it means that without the rate hikes, the core inflation rate today would not be 2.7% but 4.7%.

The Fed’s contribution to reducing core PCE

Source: Ferguson and Strom (2024)

But it also means that the Fed is responsible only for about 40% of the cumulative decline in inflation over the last two years. 60% of the drop had nothing to do with the rate hikes and was driven by global demand destruction (China, mostly) and the natural pass-through of inflation from energy price spikes and supply chain disruptions.

This leaves me unbalanced. On the one hand I am glad the Fed did what it did and helped reduce inflation. On the other hand most of the pain would have passed by now anyway and now we are stuck with the largest interest rate increase in forty years and the threat of an economy that is slowing.

But what about the other part of the dual mandate? Did the Fed manage to keep employment high and engineer a soft landing. For now it certainly sems like they did. But Ferguson and Strom put that narrative into question as well.

They look at the distribution of wealth and real income as well as consumption patterns for different income groups in the US. And they find that much of the resilience in US consumption and the US economy is driven simply by the top 10% of the country by income. Take them away and you would have had the same recession in the US as you had in Europe and the UK.

The top 10% by income have seen their real household income increase by 0.2% per year between 2019 and 2023, while the median household saw their real income drop by 0.7% p.a. and the bottom 10% by 1.2% p.a.

The wealth effect is even more pronounced thanks to a booming stock market and strong house prices that added some $21.7 trillion to the net wealth of the top 10% but only $1.8 trillion to the net wealth of the bottom 50%. And this wealth effect is what kept the top 10% of Americans spending and the economy afloat.

Change in net wealth 2020 to 2023

Source: Ferguson and Strom (2024)

Again, you can be critical of this achievement or complimentary. On the one hand it shows that the Fed and its actions have helped rich people while poor people took most of the pain of the inflation spike. On the other hand, high income households are arguably what keep the US economy afloat overall and since they had the means to spend and the wealth to do so, they were the ones who kept the US from losing jobs and sliding into a recession. You choose your interpretation according to your preferences.