A soft landing is not really a landing at all. It is a gradual slowdown in the rate of business expansion to the vicinity of the economy's long- term real growth potential - usually estimated to be somewhere around 2.5% per annum.
At this rate of growth, the proposition is that significant price pressures will not arise and the rate of inflation will level off.
I am skeptical that this will be the most probable outcome. It is a scenario that ascribes more stability to the U.S. economic system than history justifies.
Much more likely is an economic and financial trajectory that is more irregular, with periods of exceptional strength such as we experienced late last year punctuated by a quarter or two of more subdued activity.
If (that is) so, by the second half of 1995 we should be experiencing some reacceleration of business activity combined with a gradual stirring of inflationary impulses. The following nine factors will contribute to this result:
*American incomes are growing at a healthy pace. Growth in employment this year is averaging 240,000 per month as compared with an average monthly gain of 290,000 in 1994.
*American businesses are experiencing astonishing profit growth. Corporate profits have increased by 77% since the start of the economic recovery in 1991, outpacing the recovery in profits during comparable cyclical periods by 70%.
*The recent decline in intermediate and longer-term interest rates will encourage some revival of new housing activity.
*The net worth of the household sector is vastly improved.
*Credit availability is extraordinarily high, while private credit demands remain generally moderate by cyclical standards. Commercial banks have regained financial health, are strongly capitalized, are highly liquid, and are facing no effective limits to providing new loans to businesses or households. Indeed, their new-found ability and willingness to expand credit have raised the eyebrows of bank regulators, who say they are concerned that lending standards are being relaxed too much.
*The dollar's fall against major currencies has left U.S. goods and services extraordinarily competitive in world markets.
*Important drags on economic growth (including declining defense spending and weak real estate markets) are receding.
*The current monetary posture is supportive of economic growth.
*Monetary policies in key industrial countries - Japan and Germany - have become more accommodating.
In sum, higher incomes, ample liquidity and credit availability, higher net worth, and lessened structural impediments characterize an economy on the verge of a pickup in business activity, not one on the verge of a lasting slowdown.
In my view, the only obstacle to a resurgence of strong U.S. business expansion is on the supply side of the economy, reflecting a dwindling margin of excess industrial capacity and of skilled human resources.
As a result, the reacceleration of growth in the second half of this year, which should carry over well into next year, has the potential to produce progressively greater upward pressures on the rate of inflation.
Unemployment is already below conventional estimates of the rate at which wage pressures start to develop. Producer prices for crude and intermediate goods are materially higher than a year ago. Crude oil prices have started to trend upward.
In addition, the dollar's drop against the Japanese yen, the German mark, and other European currencies linked to the mark will force more and more foreign producers to raise (U.S.) prices to preserve some semblance of profitability.
Naturally, higher import prices provide an opportunity for American corporations to raise their own prices without risking a loss of market share. By the end of the year, the monthly price data may be indicating a rate of inflation of above 4% per annum, and there is a definite risk that inflation could exceed that rate by a good margin during 1996.
What will be the consequences of this confluence of likely events?
The Federal Reserve will probably raise interest rates again during the summer and fall, with the federal funds rate reaching about 7% by yearend. The yield curve will remain positively sloped, but it will flatten, with short and intermediate obligations increasing more in yield than long bonds.
Initially, the stock market should weather the next round of higher rates quite well because it will likely occur against a backdrop of still- rising profits and ample liquidity. Later on, however, as profit momentum subsides and credit conditions become conspicuously tighter, the equity market will begin to feel some strain.
The dollar will probably benefit from the likely rise in interest rates later this year, but this improvement may not last. The maturing U.S. economic expansion, when compared with much younger cyclical recoveries in the rest of the industrial world, may encourage an even greater capital shift out of U.S. financial assets next year.
In specific sectors of the U.S. financial system, diverse cyclical patterns will emerge. In mortgage obligations, there could easily be a flurry of fixed-rate financing over the near term that, later in the year, would subside and be replaced by another switch to variable-rate financing.
In contrast, business credit demands will trend higher throughout the remainder of this economic expansion. Thus far this year, there has already been a noticeable pickup in business borrowings. Short-term credit to nonfinancial business is up by $35 billion through early April, as compared to $10 billion for the same period last year.
In addition, new bond issuance by U.S. corporate borrowers here and abroad averaged almost $15 billion a month during the first quarter, as compared to a monthly average of just $11 billion in 1994. Further strong increases are likely over the next year or so, as profit momentum abates while working capital and capital expenditure requirements tend to move upward.
For commercial banks, in particular, this will (produce) substantial loan expansion and the opportunity to maintain good profit margins.
It is, however, highly unlikely that the Federal Reserve will allow an expansion in bank reserves sufficient to finance the probable increase in loans through deposit growth. More likely, banks will have to liquidate securities to finance at least a portion of the new loan demand.
Banks that treat the bulk of their securities portfolios as "held for sale" have the flexibility to accomplish this, and they should do quite well. But institutions with large securities portfolios designated as investments may be hamstrung.
Indeed, as interest rates turn upward once again, institutions with a large depreciation in the value of their existing investments face some potential risk of capital impairment.
I would also suggest that the current conventional view that commercial banks have excess capital will fade with the impending rise in bank credit.
The validity of this view will have to stand the test of how well banks fare through the entire business cycle and not just through a long period of economic recovery during which there has been substantial liquidity, extensive credit availability, and improving credit quality of borrowers. Mr. Kaufman is president of Henry Kaufman & Co., an economics consultancy in New York. This commentary is excerpted from his presentation April 24 at the CS First Boston 1995 Banking Conference.