Everyone is praying that
Federal Reserve Chairman Alan Greenspan
, with the surprise cut in interest rates Wednesday, can successfully steer the economy toward the desired and elusive soft landing.
But what, exactly, constitutes a soft landing, and can we achieve one?
In broad terms, just as a recession is defined as two consecutive quarters of negative growth in
gross domestic product
, explains Kevin A. Hassett, an economist and resident scholar at the
American Enterprise Institute
, a soft landing is an economy that slows from GDP growth of 4% or 5% to just above zero.
Its aim is to cool the economy down to a more manageable rate of growth, he says. "If you don't slow down enough to go into a recession, it's a soft landing."
With the economy running in high gear for several years, the
raised interest rates six times between June 1999 and last May in an effort to keep it from running wild. High growth threatened to trigger inflation. Now things are coming to a halt, but the brakes might be kicking in too sharply. Recent economic data, as well as continued poor earnings news and crushed consumer confidence, are signaling a sharp slowdown.
The Fed has now changed the focus of its concern to economic weakness, with Wednesday's decision to lower the key fed funds rate from 6.5% to 6%. The central bank took the unusual step to raise rates before the regular meeting of its policymaking
Federal Open Market Committee, something not done since October 1998. This seems an acknowledgement that the Fed is clearly worried that the economy is slowing too fast and may be at risk of a recession, and that Greenspan & Co. are ready to combat the slowdown.
There are already signs that GDP, a measure of all goods and services produced in the U.S., has slowed abruptly. The
recently revised downward its measure of third-quarter GDP from an estimated 2.4% pace of growth to 2.2%. That's down sharply from the blistering 5.6% pace set in the second quarter, and is the slowest rate of growth in four years.
The Fed's aim is to slow the economy enough to stimulate a modest increase in unemployment, says Mark Zandi, chief economist at
. "The potential for GDP growth next year is 4%, and so if we stay at 3% growth, the unemployment level will grow and take the pressure off wages and prices," he says, adding that there is a narrow margin of error:
Hitting the desired rate of growth is no easy operation. In 1994, Greenspan raised interest rates a number of times to cool an overheated economy and stock market. In the fourth quarter of 1994, GDP was running high at 5% growth, but slowed dramatically to 1.5% and 0.8% by the first and second quarters of 1995, respectively, making for a soft landing. The same scenario was seen in 1990 and 1991, but growth dipped into negative territory and the nation went into recession, albeit a short and shallow one.
Can the Fed pull it off this time? "I think there's less than a 50% chance of a recession," says Robert Klemkosky, chair and professor of finance in
Indiana University's Kelley School of Business
. "A soft landing is a simple concept, but if the economy is running at 5% growth then it's not easy."
An important problem now is the "reverse wealth effect," he adds. The rising stock market built up trillions of dollars of wealth by last March, making investors feel warm and fuzzy and sending the savings rate down dramatically. But the recent plunge in stock prices will produce a reverse effect, he fears.
"When stocks stumble, people entrench themselves and cut down on consumption. This will cause an economic slowdown of a greater magnitude than we originally thought."
Says Hassett of the American Enterprise Institute: "I think there's a better-than-50% chance that we'll go to negative growth in the last quarter of this year or the first two of next year. If you look at what's going on with the economic data, bad things are starting to happen."
Durable goods data show that purchases of corporate equipment are dropping off dramatically, meaning that companies are tightening their belts, he says, and employment data show a significant growth in jobless claims. "Two of the last five months showed significant job loss -- a clear sign of a recession."
Still, Hassett is optimistic: "We will have a hard landing, but we shouldn't get carried away with how hard it is," he continues. "As long as the government doesn't make dramatic changes to economic policy, the economy has a good record of handling these sorts of occurrences," he adds.
"It will not shake the fundamentals of firms. Profits will be lost, but we will not be seeing any really big problems. While the risk is high that this will fall apart, I think this time we'll make it."