Has the Federal Reserve sown the seeds of the next recession by elevating interest rates during the past year, or is a "soft landing" in sight for the nation's economy?
The question is a vital one for banks and bank stock investors. A recession would increase financial pressure on borrowers and swell credit costs at banks.
Such costs have been running well below normal levels. Bank stock prices, despite their recent slump, may not reflect the impact on earnings of larger loan-loss provisions and higher foreclosed property costs.
A soft landing, on the other hand, would be the best of all possible worlds for banks. It would imply continued expansion of the economy brisk enough to create jobs but not fast enough to stir inflation.
Whether the Fed is capable of pulling off this trickiest of all monetary policy maneuvers is the subject of much debate and some doubt among economists and bank analysts.
Some contend the Fed has never really executed a soft landing and think the feat, while perhaps not impossible, is at least unlikely right now. They predict a recession, starting late this year or next year.
Some others, while acknowledging the high-wire aspect of accomplishing a soft landing, feel current conditions may let the central bank achieve it.
Allen Sinai, chief economist at Lehman Brothers Inc., New York, rated it a possibility, but he prefers to call the maneuver a "fly-by."
"The trend in government spending, adjusted for inflation, has been down for the past four years," he pointed out. "The significance of this is that it raises the odds the Fed can slow the economy without causing a recession. The Fed received no such outside help in 1989 when it (last) attempted to engineer a soft landing."
Moreover, with inflationary pressures low right now, Mr. Sinai said, the Fed is not deliberately trying to start a recession to ensure price stability, as it did in 1989, with hopes of keeping the downturn mild.
Fed Chairman Alan Greenspan in the past year has encouraged the idea that steady 2.5% growth of the nation's gross domestic product would be about the optimal rate for both job creation and price stability.
Among the doubters is A. Gary Shilling, an economist and money manager based in Springfield, N.J. "I'm sticking to my guns on this," he said. "The idea that we just get to 2.5% GDP growth and ride into the sunset is nonsense."
"When the Fed starts raising rates because they fear inflation late in an expansion, they keep going until they get two things," he said, "a flat to inverted yield curve from (federal) funds all the way out to 30 years, and a recession."
The yield curve is the notional line traced by the yields on various Treasury securities. The curve is said to be inverted when yields on shorter maturities exceed those on longer maturities.
Mr. Shilling, former chief economist at Merrill Lynch & Co., explained last week why he did not agree with the 2.5% theory.
"The problem is that, while that may seem a reasonable rate, it is still faster than the growth in capacity and labor at that stage of the (business) cycle," he said. "Productivity growth is lousy, and you get increased production bottlenecks and inflationary pressures."
Mr. Shilling thinks that is particularly true this time around, because of developments that also account for the slow renewal of bank loan demand several years ago. This weak demand had caused the Fed to reduce rates to two-decade lows.
"A big reason the banks took a little longer to get going this time, and the expansion was slower off the mark, was that we were still rationalizing American business," he said.
"We were getting rid of the old equipment and excess people that were formerly only utilized in periods of peak demand. As a result, we have no cushion, and any growth at this point increases strains on capacity."
The Fed itself singled out high capacity utilization as a reason last Wednesday for raising short-term interest rates again, the seventh such credit tightening in 12 months.
But Mr. Shilling acknowledged that measures of capacity in use "are educated guesses at best." Others are even more dubious.
"I would like to see the Fed stop publishing capacity utilization figures because they are grossly misleading," said Sung Won Sohn, chief economist at Norwest Corp., Minneapolis. "I think we have a lot more capacity than the Fed seems to believe."
"I wish the Fed would be a little more patient," he said. "There is plenty of (monetary) restraint in the pipeline now. If I were on the Fed, I would have voted 'no' this time."
At this point, Mr. Sohn said, he sees a 35% probability of overkill and a 65% chance of a soft landing. "But if (the) Fed raises rates again, as I am sure they will before midyear, then clearly we are tipping the balance in favor of overkill," he said.
Philip Braverman, chief economist at DKB Securities Corp., New York, said he thinks the balance has already been tipped.
"Momentum will keep the economy growing and raise the risk of the Fed moving yet again, most likely in May," he said. "I think that will be the end of it and before the year is out they will start going the other way.
"GDP growth will slip below the Fed's 2.5% speed limit," he said, "but there will be no soft landing because the trajectory will not stop there, falling below 2% and the potential for a recession next year."