U.S. Outlook: Slower Growth but no Recession Makes Restoring Target Inflation Tough
- The U.S. economy has recently seen growth surprise to the upside but inflation falling faster than expected. However, progress on headline inflation is set to stall in the near term as energy prices pick up, and that will restrain consumer spending, which has been a source of recent strength, particularly if the labor market continues to gradually lose momentum. While we expect recession to be avoided, we anticipate significantly slower GDP growth in 2024, and while there will be continued progress on core inflation, a sustained return to the Fed’s 2.0% target is likely to prove difficult.
- Fed policy remains data-dependent with their current discussions on whether further tightening will be needed, with easing not yet part of the discussion, though it is likely to become so in 2024. We expect one more Fed tightening in 2023, by 25bps in November to 5.50-5.75%, with easing starting in Q2 of 2024. With inflation seen remaining above target and fiscal policy loose, easing is likely to be cautious. We expect three 25bps easings in 2024, in Q2, Q3 and Q4, leaving the rate at 4.75-5.00% at the end of the year, still well above neutral, though 25bps below the latest FOMC median dot, with our GDP forecasts being a little softer than the Fed’s.
- Forecast changes: Our forecast for 2023 GDP has been revised significantly higher, to 2.3% from 1.4%, while we now expect 2024 GDP to increase by 1.2% rather than 0.8%. While we have revised our forecast for 2024 higher, we now expect each quarter of the year to increase by less than 1.0% on an annualized basis, while in June we had expected growth to move back above 1.0% in the second half of 2024. Our inflation forecasts have been revised modestly lower, with CPI seen rising by 4.1% in 2023 rather than 4.3%, and by 3.1% in 2024 rather than 3.4%. We now expect core PCE prices to move below 3.0% y/y in Q1 2024 rather than Q3 2024, but our forecast for Q4 2024 at 2.5% is unchanged from our June projection. Our forecasts for the Fed Funds target are unchanged from June.
GDP to avoid recession but momentum will be limited through 2024
U.S. economic data has continued to surprise on the upside on activity and there has been some progress in reducing inflation. The progress in reducing inflation has probably contributed to the resilience in economic activity, by giving consumers more purchasing power. We have revised our GDP forecasts up and our inflation forecasts down. However, the economy still looks set to see a significant loss of momentum into 2024, and getting inflation down to the Fed’s 2% target is likely to prove difficult.
Since our June outlook, we have revised our forecast for 2023 GDP to 2.3% from 1.4%, with 2024 now seen at 1.2% rather than 0.8%. Q3 2023 looks set to see the strongest quarter since at least the 3.2% seen in Q3 2022. Not only has the consumer been supported by labor market strength and falling inflation, but business investment is also proving resilient with the banking sector worries seen earlier in the year fading. Fiscal policy remains supportive from both defense and non-defense spending while net exports look set to make their six straight positive contribution to quarterly GDP. Even housing has shown some improvement as mortgage rates showed signs of stabilization earlier in the year.
Looking forward however, momentum is likely to fade. The key will be consumer spending. The labor market is gradually moving back into balance, with employment growth trending below 200k per month, consistent with GDP near 2.0%. Job openings are now closer to the pre-pandemic trend of 7 million than their peak of 12 million and look set to return to normal levels by early 2024. Employment growth looks set to slow further. While further progress on core inflation is likely headline inflation is finding a near term base with energy showing renewed strength. That combined with a cooling labor market will restrain real disposable incomes. While consumer balance sheets are healthy, excess savings built up in the pandemic have been largely run-down meaning a subdued outlook for real disposable income and a subdued outlook for consumer spending. Recent gains in mortgage rates are likely to bring renewed weakness in housing, and that will further restrain consumer spending.
We no longer expect business investment to lead the economy into recession, but an already mixed picture is likely to see momentum weaken and further banking sector worries cannot be ruled out. Inventories have already lost momentum but remain quite high relative to sales and a moderate further trimming is likely to be needed. We expect net exports to remain a modest positive, with slowing domestic demand likely to restrain imports and exports having seen less of a post-pandemic rebound than imports, and thus having more upside scope. However, a strong USD and weakness in many key overseas markets are likely to keep export growth modest. Government is also likely to lose some momentum, particularly at the state and local level, assuming limited growth in tax receipts.
After a healthy Q3 we expect GDP growth to slow to 1.1% in Q4 2023, and to be below 1.0% in each quarter of 2024, with only a very marginal H2 recovery in momentum from a low of 0.5% in Q2. Our GDP view for 2024 is a little softer than the latest forecast from the FOMC, which sees 2024 GDP up by 1.5% Q4/Q4. The labor market’s loss of momentum is likely to persist through 2024, and while we do not expect significant declines in employment, growth is likely to fall behind that of the labor force, leading to a modest increase in unemployment. A significant revival in the economy is likely to need significant easing from the Fed, but if as we expect, unemployment remains low (if rising) and inflation remains above target (if falling) then the Fed is likely to be cautious. We now turn to the outlook for inflation and Fed policy.
Inflation and the Fed Policy Trajectory
Headline CPI fell to 3.0% in June 2023 from a high of 9.1% in June 2022, with the fall flattered by energy falling off its highs seen in the immediate aftermath of the invasion of Ukraine and food inflation also losing momentum. Headline inflation has subsequently edged higher. Progress continues to be made on core inflation though Yr/Yr core inflation, both CPI and PCE, remains around double the 2.0% target. There are several signals for slower inflation, notably PPI trend which has been acceptably subdued since late 2022 and several business surveys. Recent monthly core inflation data suggests a picture moving closer to 0.2% per month, which would if sustained be consistent with near target inflation, but the data has been flattered by sharp falls in a few components, such as air fares and used autos, suggesting the underlying picture is still too strong. As we move into 2024, we will see more balanced monthly inflation releases, and a softer underlying picture. However, supply of housing, in contrast to supply of goods, is still quite tight as outlined in the Fed’s latest Beige Book, suggesting we are not going to see any sharp weakness in housing inflation, while wage growth, while likely to gradually slow through 2024, at this point remains too high to be consistent with 2.0% inflation. We continue to believe that reduced globalization will prevent a return to pre-pandemic inflationary dynamics, when the Fed consistently struggled to get inflation up to the 2.0% target. Our Q4 2023 core PCE prices forecast of 3.5% is significantly below our June forecast of 4.2%, but our Q4 2024 forecast of 2.5% has not been changed, while energy is likely to contribute positively to inflation in 2024.
The budget deficit, having fallen from 14.9% of GDP in 2020 to 5.5% in 2022, is set to rise to around 6.0% of GDP in 2023 and remain there for the foreseeable future without significant policy changes, unprecedented at a time of near full employment. This is likely to help sustain inflationary pressure while the looser fiscal policy is, the tighter the appropriate monetary policy rate will be. At present the Fed is debating whether policy has already been tightened enough. We believe that strength in Q3 GDP combined with less than convincing progress on CPI will see the Fed tighten once more in 2023, by 25bps to 5.50-5.75% in November, though this remains a close call dependent on data. We continue to expect three 25bps easings in 2024, in Q2, Q3 and Q4, though easing will only commence with clear signs of cooling in the labor market and sustained subdued monthly outcomes from core inflation. Risk is that easing will start later rather than sooner than we expect, and should the Fed keep policy on hold though the remainder of 2023, easing may be delayed until Q3 of 2024, leaving the end 2024 rate at 4.75-5.00% on both late 2023 scenarios. This is 25bps lower than the 5.00-5.25% seen by the latest FOMC median dot, though our GDP forecast being a little softer than the FOMC’s justifies a slightly larger amount of easing, particularly with the dots having a modest downward skew.
Risks to the outlook, and looking towards 2024 elections
The election will be seen as a key event for 2024, though the implications for the 2024 economic outlook are modest. Despite Republican rhetoric on the deficit, fiscal policy is likely to remain loose whatever the result of the election, though policies on Ukraine and climate could change dramatically on a Trump victory (here). The election looks most likely to be a contest between President Biden and former President Trump, with potential serious challengers to Biden unlikely to enter the race without a clear deterioration in his health, and the Republican base likely to stick with Trump despite his mounting legal difficulties. Should the election take place in an environment of still low unemployment and inflation well off recent highs Biden would be the more likely winner, though a polarized and evenly divided electorate will keep the race close. The map of seats being contested gives the Republicans reasonable hopes of retaking the Senate. The House is marginally more likely to remain in Republican hands, though a stronger than expected economy could tip the balance. If the Republicans control only one chamber and Biden is re-elected, a showdown on the debt ceiling in early 2025 is more likely if it is the House that the Republicans control.
Uncertainty on the economy remains high. Should the economy maintain its current momentum, the task of restoring inflation to target would become tougher and significant Fed tightening may become necessary, at the risk of a significant recession in late 2024. Should the economy underperform our expectations, inflation would be more likely to return to target in 2024, and could even do so under a GDP outlook in line with our forecast. However, our concerns over whether inflation can be sustainably held at 2.0% would persist. In the long term, we expect the Fed will be forced to accept an inflation pace on the high side of 2.0%, contrasting sustained marginally sub-2.0% inflation before the pandemic.