Soft Landings, Hard Landings, Inflation, Oh My!

TL;DR:

Soft landing == get to low levels of inflation + avoid severe recession  

Hard Landing == get to low levels of inflation + recession & possibly deflation :(

2020 happens and the world shuts down.

In response:

• Central banks reduce overnight interest rates
  
• Central banks implement quantitative easing, which basically means they start purchasing assets from banks like government bonds to:
  
  a) reduce interest rates on medium and long term loans
  
  b) inject banks with cash they can loan out
  
• Governments begin additional financial support programs for people and businesses

This can mean things like:

• If you qualify, you get money from the government!
  
• Any payments you have to make on any variable rate loans you owe, like mortgages & credit cards, go down!
  
• Getting short and long-term fixed and variable loans are cheap and easy!
  Borrow today, spend, and pay low interest payments later!
  
• Businesses can take out cheap loans, which they can use to grow and hire more people!

What all of the above will ultimately mean is more money in the hands of the individual.

And while this has lots of upsides, a consequence that can occur as a byproduct of this is increased inflation.

Inflation

Inflation means a rise in the price of goods and services in an economy.

Practically, high inflation in the past couple of years means you might have caught yourself saying things like:

“My grocery bills have doubled from last year while my wages are the same. Everything is so much more expensive now.”

Two factors played a big role in that happening.

Increased Demand

Demand for goods and services increases when people have more money.

Anytime demand goes up for the same supply of goods and services, businesses typically respond by raising prices.

They do this to reduce the demand to a level they can meet at their current supply.

Amplify that effect on the scale of an economy full of businesses and consumers, and over time, you can hopefully see how the price levels for goods and services can rise.

Supply Reduction

Another factor that can result in increased inflation is a reduction in the supply of goods and services that can be produced in an economy.

This can occur due to supply chain issues, and/or a rise in the cost of the production of goods and services.

For example, if the price of oil increases (which it did in the recent past), the price of producing lots of goods and services in the economy increases.

One reason why is because the price of any product that has to be transported from one place to another has to increase to account for the higher cost of oil.

So if the available supply of goods and services drops..

Businesses will respond by raising prices to reduce demand to a level they can meet at the reduced supply.

In other words, inflation increases.

Combined

When both the above two factors are at play simultaneously, as they were in the recent past, the effects of inflation are amplified.

And that's what we saw happen globally over the past couple of years.

Is all inflation bad?

Moderate levels of inflation are desirable in an economy.

Most central banks worldwide aim to keep inflation at around 2%.

That means a year from now, central banks want to see the cost for the products the average person consumes like groceries, clothes, utilities and so on get 2% more expensive on average.

There are many reasons for this, among which are:

• Rising inflation encourages people to spend money rather than hoard it away, which supports economic growth.
  
  The idea being that if you know that you’ll be able to exchange your money for less goods and services in the future because prices are going up 2%..
  
  You’re more likely to spend and invest now, supporting economic growth.
  
• If inflation is 2%, businesses and banks will be incentivized to invest the money they have to grow it by at least by 2%, supporting economic growth.
  
  So banks, rather than sitting on the cash they have available, take actions like issuing more loans to businesses and consumers.
  
  Similarly, businesses invest in new projects, hire more people, and so on.
  
• The 2% inflation rate target allows for a safe buffer zone to avoid the opposite of inflation, which is deflation.
  
  Deflation is defined as the fall in the general price level of goods and services in an economy, which can be disastrous.
  
• Maintaining 2% inflation allows prices to remain stable and predictable, helping businesses and individuals plan for the future.

An insight that can be made is that normally, central banks want consumers and businesses and banks to be active participants in the economy.

Spend and invest!

And while not all inflation is bad, high-levels of inflation like those experienced in the past year are.

Here are some reasons why:

• Unless a business has pricing power, allowing it to raise rates in step with inflation, a business's earnings will decrease in a highly inflationary environment.
  
  This means less money for businesses to invest in projects and hire employees.
  
  Ultimately resulting in a slowdown in economic growth.
  
• The cost of production for businesses increases in an inflationary environment, due to production inputs being more expensive.
  
  This can result in businesses reducing production, resulting in supply shortages and higher inflation still.
  
• If inflation is volatile, businesses and consumers can find it difficult to plan and budget appropriately for the future, potentially impacting economic growth.
  
• In an inflationary environment, consumers will have to spend more to get the same amounts of goods and services.
  
  In addition, wages typically take time to rise in step with inflation, if they rise at all.
  
  Combined, this means the quality of life of consumers can be severely impacted in inflationary times.
  
• Consumers will prioritise spending on necessities and reduce spending on anything non-essential in an inflationary period.
  
  This can impact economic growth in various segments of an economy.
  
• Any cash savings that an individual has built up will be eroded in terms of purchasing power, unless inflation is tamed and brought back down to normal levels.
  
  This can result in individuals spending more and saving less, leading to higher levels of inflation.
  
• If inflation remains at elevated levels for a prolonged period of time, it's possible for hyperinflation to occur.
  
  In hyperinflation, the purchasing power of an economy's currency can be eroded to the point the currency becomes worthless.
  
  In other words, a situation a central bank wants to avoid at all costs.

Currently..

New Measures

Starting in 2022, central banks and governments implemented measures to combat high levels of inflation, including actions like:

• Central banks increase overnight interest rates
• Central banks implement quantitative tightening, meaning they stop buying assets like government bonds from banks.
• Governments cut back on additional financial aid programs they started after 2020

As a result:

• Interest payments on variable rate loans get way more expensive.
• Savings accounts pay higher rates of interest
• Medium and long term loans become more expensive and difficult to obtain.

Impact

If you recall above, where I talked about the factors causing the recent high inflation, I mentioned two factors.

One of them was high consumer demand caused in part by policies implemented by central banks and governments after 2020.

Well, now, the opposite is occurring.

Central banks can’t fix supply shortages..

But what they can do is reduce consumer demand for goods and services.  

Which they do through the measures mentioned above, which act to decrease the amount of money consumers have to spend and invest.

Three ways this can reduce inflation are:

• Individuals holding variable rate loans on loans like mortgages and credit cards will have their monthly payments increase.
  
  Meaning they have lower amounts of cash to spend on goods and services..
  
  Which reduces demand in the economy, leads to businesses cutting prices, and reduces inflation.
  
• Obtaining loans of any length becomes more expensive and difficult to do.
  
  This discourages borrowing for both consumers and businesses and slows economic growth.
  
  And therefore results in a decrease in inflation.
  
  For example, medium-term and long-term mortgages become more expensive, resulting in a decrease in demand for homes.
  
  And ultimately a decrease in housing prices.
  
  It also becomes more expensive for businesses to take out loans to do things like fund projects and hire employees.
  
• In a high interest environment, interest rates on savings accounts go up.
  
  This can encourage consumers to save money instead of spending it, which reduces consumer demand, and results in businesses dropping prices.

These measures do have drawbacks, the biggest of which is probably a slowdown in economic growth.

The economic impact leads us finally to soft landings and hard landings, which are hopefully simple to understand after all we’ve discussed! :)

Soft Landings & Hard Landings

A soft landing is a situation in which a central bank successfully reduces inflation to the 2% target, while avoiding a recession.

This situation is the ideal when central banks combat inflation.

This means that central banks have successfully slowed down economic activity enough to cause businesses to drop prices such that inflation hits the 2% target..

While not harming economic activity to the point where unemployment significantly increases, businesses go bankrupt, and so on.

In contrast, a hard landing is a situation in which a central bank may still succeed in reducing inflation to the 2% target..

But a recession is caused in the process of doing so, involving high levels of unemployment, bankruptcies, potentially bailouts and so on.

In a hard landing, central banks can also overshoot the 2% inflation rate target and actually cause deflation, which can be disastrous for an economy.

So that's inflation, hard landings, and soft landings in a nutshell.

This was meant to be a high-level summary, so I would encourage you to dive deeper if you are interested!

Hopefully this article helped clarify some things for you, long though it may be :)

If you have any questions or feedback or would just like to connect, I'd love to hear from you! Feel free to send me a LinkedIn message or drop me an email at jesse@jessekhaira.com :)