US Soft Landing Confirmed – Is it Durable?

Mabrouk Chetouane (MC): Since the beginning of the year, we have seen many different scenarios predicted for the US economy, ranging from recession to expansion. In your opinion, where are we in the US economic cycle? Have we initiated a soft landing?

Garrett Melson (GM): The debate between hard and soft landing has now been put to bed. I think we've had a soft landing.

Inflation is still modestly above target and the narrative has shifted somewhat given the altered trade backdrop. But inflation is now close enough to the target and both the labour market and growth are holding up – that is, effectively, a soft landing. To my mind, the bigger debate is where we go from here.

On the surface, we are roughly back to where we started the year. And, while the tariffs have been unwound significantly, they are still likely to settle in at a higher level than where we started the year. It’s not a drag that necessarily pushes the US into recession, but it is an incremental headwind that speaks to the bigger story in our mind, which is that the US economy continues to cool under the surface.

I think the real risk for the economy right now isn't so much external shocks or even tariffs and trade, it's that the Fed remains sidelined by worries about the upside inflation risks from tariffs, and so it keeps policy rates steady while the nominal economy continues to cool. That would effectively be passive policy tightening, which could really exacerbate the cooling process that is already underway.

The good news is that there is a pretty easy solution for what is ailing the economy. A few of the rate-sensitive areas in the economy, namely housing and, to a somewhat lesser degree, CapEx, non-residential investment, are showing the effects of tight policy rates, and it doesn't take much in terms of easing policy rates to help unlock activity there.

But I think the big story is that a lot of the US economy is kind of in stasis. The labour market continues to cool. The housing market is stuck in the mud as well. If you continue to see softness in construction data, which is our expectation here, then the lone pillar supporting everything is consumption.

And there I think the big story is building slack in the labour markets translates to softer wage growth, which translates to softer consumption and softer nominal growth. And I think that is the big risk over the next couple of quarters.

MC: What are your thoughts regarding monetary policy in the US? We’ve heard US Fed Chair, Jay Powell, saying a couple of weeks ago at the latest FOMC meeting that the current level of interest rates and monetary policy is «slightly restrictive». Given what you have just said, do you think that the Fed is behind the curve, or do you think there is no need to rush to lower rates just yet?

GM: I think the Fed is somewhat intentionally setting itself up to be behind the curve. Part of that is, I think, maybe a slight misread of labour market dynamics. We have heard repeatedly from Powell that the labour market remains solid and that is true if you look at the headline numbers.

But, if you look under the surface, there's a stronger case to be made that there are a number of red flags waving, which are different from the dynamics last year.

The unemployment rate has risen for each of the last four months in unrounded terms, almost a total of 25 basis points. So it's a pretty steady but slow grind higher here and the Fed has been pretty clear that they're really focusing on the price side of the mandate right now. There's still max uncertainty on either side of that dual mandate.

But, for now, they've shifted into this forecast dependency mode where they expect upside inflation risk from tariffs, as do we, but we see the bigger risks on the growth side of the dual mandate. If those price increases which are essentially a tax hike on consumption in the form of tariffs, are occurring against a backdrop of cooling nominal incomes, that just translates to demand destruction, not some sort of persistent inflationary cycle.

So, that's our bigger takeaway. And you even heard Powell somewhat acknowledge that, saying that, if it weren't for the tariff risks, they would probably be cutting.

The implication of this is that if they don’t cut now and growth cools more, it just means they probably have to cut a little bit more later.

I think it's pretty clear from our perspective when you look at rate sensitive areas of the economy, it just doesn't work where rates are right now and the Fed is still kind of waiting for that greater clarity, which may take some time, and you might get a good amount of cooling in the labour market between now and then that just translates to maybe more cuts than what the Fed expects and more cuts than what's priced in.

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