Soft landing in quicksand?

Fed: The Federal Reserve may still be over-optimistic on the US economy. The Federal Open Market Committee’s growth forecasts fell in June from the committee’s April projections, but the FOMC’s gloomiest member still sees a soft landing scenario with 2.9 per cent growth in 2010 and 2011. Yet recent data could be read as pointing to a more marked slowdown, consistent with fiscal and monetary policy locked into extremism.

The Fed’s lowering of both growth and inflation projections for 2010 and 2011 rightly reflects financial woes in Europe that have caused a marked strengthening of the dollar and a flight into the safety of Treasuries. That should reduce inflationary pressure on the US economy, but also slow its growth and increase the balance of payments deficit. The most recent statistics on production, balance of payments, import prices and retail sales confirm this expectation.

 

But the Fed’s downward adjustment may not go far enough. First quarter GDP growth was only 2.7 per cent, of which well over half represented an inventory swing from de-stocking to re-stocking. Given the recent apparent slowdown, reported GDP growth may well decelerate rather than accelerate in coming quarters. Even the FOMC participant with the lowest forecast may therefore be sporting rose-tinted spectacles.

A slowdown in growth so soon after a downturn would seem surprising, based on past patterns which show vigorous recoveries after deep recessions. Nevertheless, there are a number of possible explanations. The 2008-09 recession was atypically caused by a financial collapse. Lending to small businesses, for example, still remains deeply depressed.

That is exacerbated by real short-term interest rates that have been held below zero for almost two years, and based on the Fed’s mild inflation projections will continue to be so for some time. That makes small business lending relatively unprofitable for banks. Further, hugely increased government spending has produced a deficit that remains by far at record peacetime levels. Together with a tide of new regulations in healthcare and finance, that brings considerable economic uncertainty. The Fed may of course get its “soft landing”. But the danger is that the softness could be economic quicksand.