A hard landing, on the other hand, is when central banks tighten monetary policy too much, leading to an economic downturn.
Stagflation is a situation of high inflation and low growth. It can be caused by central banks not being able to balance their inflation-fighting efforts with stimulating the economy.
Soft landing as an ideal
Soft landing is considered the ideal in an economy, as policymakers get price pressures lower without much, or any, damage to the labor market or real economy. The goal is to have a so-called Goldilocks situation: not too hot and not too cold.
Achieving a soft landing is more likely when there is coordination between the central bank and other economic policymakers. In the US, this would be the Federal Reserve, the Treasury Department, and Congress. Other countries have similar institutions.
The main tool for achieving a soft landing is monetary policy by prudently lowering demand (money and credit) to better match it with supply, which the central bank uses to control the money supply and credit creation.
Fiscal policy, which is set by elected officials, can also play a role in getting an economy to slow down without going into recession.
How it works
The idea behind a soft landing is that it’s possible to get prices under control without wrecking the economy.
The way it’s supposed to work is that the central bank raises interest rates enough to slow down economic activity and reduce inflationary pressures. At the same time, fiscal policymakers may use tax cuts or spending increases to cushion the blow to growth.
For example, if interest rates rise to a point that the slowdown in credit creation causes spending growth to run negative, the government can fill in that hole through spending of its own in a targeted way or via tax cuts.
The reality, however, is that it’s often difficult to achieve a soft landing.
There have been several episodes in which economies have slowed too much and gone into recession. And there have been other times when inflation has remained high despite higher interest rates.
One recent example of a failed soft landing attempt was in 2006 and 2007, when the Federal Reserve tried to raise rates without slowing the economy too much.
The problem in 2006-07 wasn’t the averages – both growth and inflation looked fine – but a concentrated problem in residential real estate (i.e., housing) with too much debt and not enough income to service it.
Tightening brought about the result of a housing market crash and the Great Recession.
There’s also the risk that central banks could overshoot on interest rates and trigger a recession. This is what happened in the early 1990s, when the Fed raised rates too much to fight inflation. It led to a recession in 1990-91.
How realistic is it for central banks to engineer a ‘soft landing’?
Central banks face a trade-off between real growth and inflation in such a way that the interest rate required to get inflation down is too high relative to what the markets and economy can tolerate.
So, if inflation in an economy is high, the idea that the Fed (or other central banks) will be able to engineer significantly lower inflation while taking their foot off the pedal is optimistic.
Often, at a point in a tightening cycle, a central bank may effectively suspend “forward guidance”, which is its way of communicating to the markets what they’re going to do ahead of time.
A volatile bond market is an enemy for risk assets, which is most likely when interest rate expectations aren’t anchored.
Central banks may often describe this as being “data dependent”.
So, for example, if the next set of inflation data is worse than expected in absolute terms, then it can add more volatility back into bonds markets by causing forward rate expectations to run higher, producing a decline in risk assets.
Ditching forward guidance might be the opportune monetary policy strategy when rates are in a place where they are neither too loose nor too restrictive.
But when there is no anchor for bonds markets, it’s unlikely that implied volatility will fall.
And higher volatility in the largest, most liquid bonds markets (such as US Treasuries) usually means higher risk premiums in the market in other asset classes, which is another drag on risk assets, holding all else equal.
Inflation can easily become sticky when price increases start becoming placed into forward contracts.
And there are also cases where a general inflation psychology takes hold where workers expect higher wages to offset cost-of-living increases, which companies pass off in the form of higher prices for goods and services, making it self-fulfilling.
Inflation is not an easy thing to kill off, so central banks generally have to hike rates into restrictive territory, triggering a recession with damage to the labor market and broader economy in conjunction.
Soft Landing vs. Hard Landing vs. Stagflation – FAQs
What is a soft landing?
A soft landing is an economic scenario in which growth slows but does not decrease sharply, and inflation slows as well.
A soft landing is the ideal situation for an economy that needs to be slowed down from excess inflationary pressure.
What is a hard landing?
A hard landing is an economic scenario in which growth decreases sharply, and inflation increases.
A hard landing can be caused by a central bank raising interest rates too much, or by a sudden stop in credit growth.
The 1981-82 recession in the US was an example of a hard landing when Fed Chairman Paul Volcker increased interest rates to the highest level in the country’s history to finally stamp out the high, persistent inflation that had characterized the past decade.
What is stagflation?
Stagflation is an economic scenario in which growth is slow and inflation is high.
Stagflation can be caused by a variety of factors, including oil price shocks, supply-side shocks, or too much demand.
What is the difference between a soft landing and a hard landing?
The main difference between a soft landing and a hard landing is the rate of change in economic growth and inflation.
A soft landing is an economic scenario in which growth slows but does not decrease sharply, and inflation remains low.
A hard landing is an economic scenario in which growth decreases sharply and inflation increases.
What is the difference between a hard landing and stagflation?
The main difference between a hard landing and stagflation is the rate of change in economic growth.
A hard landing is an economic scenario in which growth decreases sharply as well as inflation. Stagflation is an economic scenario in which growth is slow and inflation is high.
Summary – Soft Landing vs. Hard Landing vs. Stagflation
A soft landing is an economic situation where the rate of inflation falls without too severely impacting growth.
A hard landing is when central banks tighten monetary policy too much, leading to an economic downturn.
Stagflation is a situation of high inflation and low growth. It can be caused by central banks not doing enough to fight inflation while also not wanting to send growth to a negative level.