What Is an Economic Soft Patch?

What Is a Soft Patch?

The term “soft patch” refers to a period in which the economy has slowed down amidst a larger trend of economic growth. The term is often used informally in the financial media and in statements issued by the U.S. Federal Reserve when describing periods of economic weakness.

Understanding a Soft Patch

The term “soft patch” is often used to describe a decline in the real gross domestic product (real GDP) that lasts for two or three quarters at a time. A two-quarter soft patch occurs when the gross domestic product (GDP) growth in the two most recent quarters is less than the growth during the preceding quarter. Similarly, a three-quarter soft patch occurs when the three most recent quarters reflect lower growth than the quarter immediately prior.

The official definition of a recession is also characterized by a decline in overall economic activity, including GDP, for several months. A soft patch is defined with a little less rigidity than a recession and occurs between troughs and peaks as it is only used during periods of overall expansion. If an economy continued its decline in GDP, then that would not indicate a soft patch but rather a market reversal towards a recession and possibly a depression.

Alan Greenspan popularized the term during his tenure as chair of the Federal Reserve between 1987 and 2006. However, you can find mentions of the term in Federal Reserve publications from as far back as the 1940s.

Despite its common usage, there is no precise and generally accepted definition of what a soft patch really means. For instance, the term is also used to describe circumstances in which GDP has slowed in response to a short-term rise in commodity prices. Market participants primarily use the term to indicate a general slowdown of the economy that could potentially impact investors, businesses, and employment.

Soft Patches in the Economy

The National Bureau of Economic Research (NBER) has published data between 1950 and 2020 of the U.S. economy. This research demonstrates periods that may be considered “soft patches”. For example, from Q4 2019 to Q2 2020, the world spiraled into the COVID-19 pandemic. In some contexts, this short could be defined as a soft patch as it resulted in only two quarters of economic (yet very drastic) contractions.

This poses the limitation that it can be difficult to tell how significant an event each soft patch is. Through this analysis, one can confirm that soft patches are a part of the business cycle and are not necessarily harbingers of a prolonged economic decline.

With this in mind, it is easy to understand why soft patches remain a topic of interest to financial media and policymakers alike. All market participants are understandably concerned with where we stand in relation to the overall business cycle since changes in that cycle will inevitably trigger reallocations of capital throughout different types of assets, thereby impacting investors’ portfolios.

As an example, the Federal Reserve keeps historical record of soft patches. For instance, it indicated that between 1953 and 2007, the U.S. incurred 69 two-quarter soft patches. Between 1957 and 2001, the U.S. incurred 52 three-quarter soft patches. Having this information and knowing how the economy responded to certain monetary policies can be critical in future decision making on how governments should return to economic downturns.

What Causes a Soft Patch?

A soft patch in financial markets and the economy can be caused by a combination of things. Here are some specific factors that may or may not contribute to a soft patch:

• Global External Shocks: External shocks such as geopolitical tensions, natural disasters, or unexpected global events can disrupt economic activity and confidence. For example, the COVID-19 pandemic in 2020 created a significant external shock, requiring immediate government intervention.
• Changes in Consumer and Business Confidence: Declines in consumer and business confidence can lead to reduced spending and investment. This may happen when people are just uncertain about the economic outlook and want to be more defensive with their personal spending.
• Shifts in Government Policies: Changes in government policies, particularly fiscal and monetary policies, can influence economic conditions. For example, tightening monetary policy by raising interest rates or implementing austerity measures can contribute to a soft patch by reducing consumer spending and business investment. Note that this may be intentional in response to other economic factors (i.e. combatting inflation may cause a soft patch).
• Industry-Specific Challenges: Challenges within specific industries can contribute to economic soft patches. The dot-com bubble burst in the early 2000s is an example where challenges in the technology sector contributed to an economic slowdown across all markets.
• Financial Market Disruptions: On a very similar note, disruptions in financial markets can have cascading effects on the broader economy. The global financial crisis of 2008, triggered by the subprime mortgage crisis, is a good example where financial market disruptions led to a severe economic downturn.
• High Levels of Debt: High levels of debt, both at the consumer and corporate levels, can create vulnerabilities. When debt becomes unsustainable, it can lead to reduced spending, increased defaults, and a contraction in economic activity. The 1980s Latin American debt crisis is an historical example of high levels of debt contributing to economic challenges.
• Commodity Price Volatility: Sharp movements in commodity prices such as oil or agricultural commodities can impact industries and countries heavily dependent on these resources. Fluctuations in commodity prices can lead to economic challenges; for example, consider the 1970s oil crisis.

Benefits of Soft Patches

Soft patches are largely considered negative as they indicate that the economy is slowing down, companies may be less profitable, and employment may slow. However, there are some benefits that investors can think about when going through a soft patch.

During a soft patch, businesses may face reduced demand for their products or services. This can prompt them to evaluate their operations, identify inefficiencies, and make strategic adjustments to improve productivity and competitiveness. This process of realignment can actually make companies stronger and position them for even better future success.

From a portfolio perspective, lower asset prices during economic downturns create opportunities to buy at better prices. Investors with a long-term perspective or long investment horizon may benefit, though those with a shorter investment window may not.

Governments and central banks often respond to soft patches with monetary and fiscal policy adjustments. For instance, the U.S. went through a period of lowered rates and subdued government spending at the turn of the millennium in response to a soft patch. These measures can not only mitigate the temporary economic downturn but bolster the economy for future stronger growth.

Soft Patch vs. Recession

A soft patch in the economy differs from a recession or economic downturn primarily in terms of severity, duration, and the overall impact on economic indicators. A soft patch refers to a temporary period of slower economic growth. In contrast, a recession is a more prolonged and pronounced downturn in economic activity.

Recessions revolve broader and deeper contractions across multiple sectors, leading to more serious levels of increased unemployment, reduced consumer spending, and a decline in business investment. Recessions result in more significant disruptions to the overall economic landscape, with a lasting impact on employment, income levels, and corporate profits. Soft patches may be considered economic downturns but to a much smaller degree.

Policymakers often respond differently to these situations, with more targeted and short-term measures applied during a soft patch. Recessions may require more comprehensive and sustained policy interventions.

The Bottom Line

A soft patch in the economy refers to a temporary period of slower economic growth characterized by a mild deceleration in certain economic indicators. Unlike a recession, a soft patch is typically of shorter duration and less severe, often representing a transient phase of economic adjustment.