U.S. Outlook: No Recession, but Subdued Growth Will Help to Reduce Inflation

GDP outlook subdued but not recessionary

U.S. economic data has tended to surprise on the upside in recent months, most notably employment growth and most significantly core PCE prices, where the underlying trend appears stuck at a pace a little above 4.0% on an annualized basis. This is off the highs seen around mid-2022, but still over double the Fed’s 2.0% target. The GDP pace appears quite modest however. Q1’s 1.3% increase was above our expectation in March but below the market consensus. Weighing against mostly positive data in calculations for Q2 GDP is a wider trade deficit in April, while a slowing workweek is offsetting strength in employment growth to leave aggregate hours worked consistent with subdued GDP growth in Q2. 

Consumer spending is supported by strong employment growth and falling headline inflation even as core rates remain stubborn. There appears to be little prospect of sharp near term job losses, but we still expect a gradual loss of labor market momentum. With the workweek now back at pre-pandemic levels, slowing momentum should become increasingly reflected by slowing employment growth rather than a slowing workweek. Business investment is a downside risk, particularly given recent stress in the banking sector, though the Fed’s May Senior Loan Officer Opinion Survey did not show a dramatic deterioration from what was already quite a negative picture in February. Inventories, even after weakness in Q1, still appear in need of some trimming. Housing however has been a notable area of improvement in recent data, and that suggests that rates at current levels are restraining interest-sensitive sectors less than some expected. Less negative housing sector data is likely to provide some offset for increased weakness in business investment though any further Fed tightening will limit the housing sector upside. Government, supported by investments on climate and defense, looks set to remain positive with the cuts in the debt ceiling deal quite modest, while the deal itself removes a significant source of downside economic risk. Net exports made a weak start to Q2, but are not showing any clear trend.

Overall, the growth outlook looks quite subdued but not clearly negative. GDP growth looks more likely to slow than accelerate in the second half of the year assuming some loss of labor market momentum. We no longer expect quarterly declines, but look for growth of below 1.0% annualized for five straight quarters. This is a picture where quarterly volatility could easily deliver a slightly negative quarter or two. Growth is likely to get some support in 2024 from falling inflation lifting real disposable income and the start of Fed easing, though the pace of GDP growth is likely to be subdued in both 2023, at 1.4%, and 2024, at 0.8%, on an annual basis. On a Q4/Q4 basis we expect GDP to rise by 0.7% in 2023, slightly lower than a 1.0% Fed estimate. We expect a 1.1% increase in 2024 Q4/Q4, gradually picking up on an annualized basis to a near potential 1.5% in Q4 2024 from a low of 0.2% in Q4 2023. Our 2024 view is a little above the 1.1% Q4/Q4 increase seen by the Fed.

Inflation and the Fed Policy Trajectory

Core inflation has been worryingly stubborn. Y/Y growth in core PCE prices has spent the six months to April stuck in a narrow 4.6% to 4.8% range while the 3-month annualized rate has been between 4.2% and 5.0% for 13 straight months. This disappointing performance means we now expect Y/Y core PCE price growth to remain above 4.0% through 2023. Fading food and energy inflation mean we have not had to revise up our forecasts for overall PCE prices as sharply, with the Y/Y pace now below that of the core and set to fall below 4.0% in Q2. There are however some grounds for optimism on the core rate. Supply problems are now largely over, while demand has only modest momentum. Wages, seen by the Fed as the key to core service inflation excluding housing, are showing mixed data, though there has been a slowing in unit labor costs, while average hourly earnings in the non-farm payroll are now trending near 0.3% per month, down from highs of around 0.5% in late 2021, despite continued labor market tightness. Trend in core PPI has been running around 0.2% per month since mid-2022. We expect annualized growth in core PCE prices to fall below 4.0% in the second half of 2023 and below 3.0% in 2024, though in a less globalized world and without a recession getting the pace back to 2.0% is likely to prove difficult. We expect 2024 to see the year end with core PCE inflation at 2.5% y/y, with quarterly annualized rates stabilizing around that level.

Once the current stubbornly stable picture from core inflation starts to move lower, we expect the Fed will feel it is a position to cease tightening. Currently the Fed is weighing the risks of over-tightening, mindful of policy lags, and the need to move core inflation lower. That suggests a strategy of moving at alternate meetings should data remain strong. A further 25bps tightening in July, taking the Fed Funds target to 5.25%-5.50% looks likely unless key data surprises significantly to the downside. Another move after that, as projected in the Fed dots, is a closer call, as we expect inflation and growth will both be slowing in the second half of 2023. Still, our forecasts for core PCE prices are a little higher than the Fed’s, and we put more weight on that than GDP forecasts that are slightly lower than the Fed’s, at least in the remainder of 2023, particularly given that we are no longer projecting a technical recession. We therefore expect the Fed to match their dots, and deliver a final 25bps move in November. 

A less restrictive policy is likely to require further progress on inflation, probably requiring quarterly annualized rates moving below 3.0%, and signs of easing in labor market tightness. We expect those conditions to be in place by early 2024. However, we do not forecast easing to quickly follow the final tightening unless there are clear signs of recession or inflationary data consistent with a return to target. We expect the Fed to hold rates through Q1 before easing by 25bps in Q2, Q3 and Q4 of 2024, leaving us projecting 75bps of easing in 2024, less than the 100bps implied by the FOMC’s dots. Given that we see GDP growth gaining some momentum in late 2024 and inflation remaining above target, there appears to be no clear case for the Fed easing at a faster pace. We expect a pattern of quarterly 25bps easing to continue in 2025, which would put the rate at 3.75%-4.0% at the year end, which is clearly above neutral. As long as the rate remains above neutral and recession is avoided we expect the Fed to maintain a steady pace of balance sheet reduction. In the long term, a sustained inflation pace on the 2% target will be difficult to achieve. Ultimately we believe the Fed will conclude that inflation within 1%, on either side, of its 2% target is acceptable. 

Risks to the outlook, and looking towards 2024 elections

Uncertainty remains high, but extreme scenarios of accelerating inflation or a deep recession are looking less likely, with the reaching of a debt ceiling deal without aggressive near term cuts in government spending significantly reducing the downside risks. However, there remain upside and downside risks to both growth and inflation. Despite the resilience of recent data, we would see scenarios of upside inflationary risk to our own forecasts, which slightly exceed the Fed’s, as relatively low, though not to be dismissed. Should these scenarios materialize however, the market impact would be significant as recession would be likely, perhaps in the near term, but even if near term growth holds up the Fed may be forced into ensuring an eventual hard landing. Scenarios of downside inflationary risks are more likely, but market impact would be more modest, as the Fed could then act decisively if the economy weakened but would act cautiously if the economy did not. 

Elections will take place in November 2024, and another contest between President Joe Biden and former President Donald Trump looks like the most likely scenario at the moment, though this assumes Biden is not forced out by a significant deterioration in health. Age could also become an issue for Trump, who is more significantly facing increasing legal risks. The latter are unlikely to prevent him becoming the Republican nominee, but are likely to hurt him in November. This leaves the reelection of Biden the more likely scenario, particularly if, as we expect, the economy is able to avoid a recession and inflation falls significantly, even if not to the Fed’s target. Republicans have good prospects of retaking the Senate with more vulnerable Democrats than Republicans up for re-election, though being too closely identified with Trump could be a risk for Republican candidates. The House will be a close call, and may depend on how disciplined House Republicans are. Divided government would set the stage for another debt ceiling showdown in early 2025. Risks of a crisis emerging would be higher in the case of Republican control of the House. If Democrats gain control of the House, a Republican Senate would be unlikely to seriously risk a debt default.