Sticking the landing

Those on holiday over August will wonder what all the fuss was about as the US growth scare appears to have ended as quickly as it began. The next few months will likely decide if the US economy has achieved the elusive ‘soft landing’.

To achieve a durable soft landing requires inflation to reach target, unemployment to stabilise and policy to be returned to neutral. We believe the chances of pulling this off are higher now than one or two years ago when it appeared as if the economy was heading for a Fed-induced recession to eliminate the overheating. While many risks remain, especially political, by the end of next year it seems – in our view – more likely than not that the US will still be growing steadily.

To help us with our assessment we have been using a consistent set of indicators over the last few years. Admittedly, they gave a false signal in 2022 and 2023. It would be the ultimate irony if the US slipped into recession over the next few months despite their recent improvement.

The approach is designed to identify the phase in the cycle and the economic vulnerabilities. The recent improvement does not mean the US is ‘all clear’ for a multi-year expansion. The path from ‘late-cycle’ overheating to recession could include a period where growth cools, the indicators improve and it looks like a soft landing.

So what has changed?

The recession indicators are largely based off balance sheet and other data, which are relatively stable and tend to change only slowly. In our latest update, the indicators have continued to edge in a more favourable direction.

For instance, the Senior Loan Officer Survey has nearly returned to neutral. This means credit growth could be less likely to slow further from here. Crucially, inflationary pressure has also eased. Goods price inflation has been benign for several quarters, but now services inflation appears to be cooling and the long-anticipated decline in rental inflation has arrived.

While we still have some concerns about elevated earnings expectations, profit margins have held up better than we expected, placing the corporate variables in a healthier position. All this makes the recession indicators look less ‘late cycle’ and at the same time, the Fed has signalled it plans to steadily make monetary policy less restrictive.

The labour market has been rebalancing, but as payrolls slow and unemployment rises this creates concern. For example, last month’s triggering of the Sahm rule (once unemployment rises 0.5ppt in a year) typically signals a recession. In addition, the softer the landing, the more likely the indicators stay ‘late cycle’. A somewhat bumpy landing with a further rise in unemployment in theory could make the subsequent expansion more durable as it reduces imbalances, creates more slack and puts further downward pressure on wage inflation.

The framework is not driven by fluctuations in financial markets, although if yields continue to fall in response to lower inflation and expected Fed cuts, that could help to improve the chances of a durable expansion.

It is also worth considering the unique nature of the COVID-19 shock and dramatic shift in the supply that has made interpretation of our recession indicators more challenging. The supply shocks of 2022 brought forward the late-cycle stage, while the reversal of the shocks in 2023, pushed the late-cycle stage back out again.

As things settle down, the US still appears to be relatively late in the cycle. This phase can last many quarters, especially, when there is no immediate or obvious catalyst for a recession.

Yet to delay a recession on a multi-year horizon probably requires a sustained improvement in the supply side and the Fed to carefully calibrate rates back to neutral. Continued strong immigration alongside artificial intelligence-driven productivity improvements could potentially deliver this.

Assumptions, opinions and estimates are provided for illustrative purposes only. There is no guarantee that any forecasts made will come to pass.