U.S. Outlook: Two Subdued Years for the Economy as Inflation Falls Only Gradually

Source: Federal Reserve, Bureau of Economic Analysis, Bureau of Labor Statistics, Continuum Economics

Source: Continuum Economics

Two Straight Subdued Years for the U.S Economy

The U.S. economy ended 2022 with renewed momentum. Consumers look healthy with the second half of 2022 seeing renewed growth in real disposable income supported by resilience in the labor market and slower inflation. However, we see a less positive outlook for investment, with manufacturing surveys mostly negative and the Fed’s Senior Loan Officer Survey showing declining demand for commercial and industrial loans. That was the case even before the sudden emergence of downside risks in the banking sector, which are likely to lead to a tightening of lending standards, further depressing the investment outlook. Inventory growth was strong in late 2022 and looks set to slow, while a positive net exports picture in late 2022, supported by the impact of the Ukraine war and supply disruptions in China, is unlikely to persist. The housing sector is weak and looks set to remain so even if Fed tightening comes to an end, with lending standards for mortgages also likely to be tightened.

We expect Q1 GDP to be quite subdued despite a stronger performance from consumer spending, and the economy to see two straight quarters of declining GDP in Q2 and Q3. However, we expect the declines to be marginal, in fact less steep than those seen in the first half of 2022, which was not classified as a recession. The labor market may lose some momentum, but high vacancy levels suggest a sharp rise in unemployment is unlikely.

Optimism on inflation has faded since the softer data of Q4 2022 was revised higher, and early 2023 data came in quite firm. Goods inflation has slowed as supply conditions improve, but negative outcomes from components such as used autos, which are reversing large positive contributions to inflation after the end of the pandemic, cannot continue indefinitely. A weak housing market will slow housing inflation significantly, which will make the inflation headlines look better, but signs of progress on core services excluding housing remain absent. PPI inflation has lost momentum, and there are even tentative signs of a slowing in wage growth despite the continued tightness of the labor market and this provides some encouragement that inflation will fall. However, unless the economy sees a sharp slide leading to a rapid rise in unemployment, the pace of progress looks set to be frustratingly slow.

Resilience in inflation will restrain future growth in real disposable income, while the lagged impact of tighter Fed policy will act as an increasing weight on the economy. While we expect GDP growth to resume in Q4 2023, we expect growth to remain below potential for the first three quarters of 2024, and 2024 GDP to rise by only 0.7% on a y/y basis, compared to 0.8% in 2023. On a Q4/Q4 basis however 2024 GDP will be up by 1.3%, compared to a 0.1% decline in 2023.

Source: Federal Reserve, Bureau of Economic Analysis, Bureau of Labor Statistics, Continuum Economics

Inflation and the Fed Policy Trajectory

We are expecting inflation to fall frustratingly slowly, with y/y growth in core PCE prices remaining above the 2% target at the end of 2024, and not even moving below 3% until the second half of 2024, though on a quarterly annualized basis we expect the first quarter below 3% to be Q4 of 2023. The labor market will gradually move into a better balance, as vacancies, now running at over 10 million, return to pre-pandemic levels around 7 million, though this may not be seen until late 2023. Job growth will eventually slow to levels consistent with below trend GDP growth, but we do not expect sharp declines in employment; and unemployment is unlikely to move much above 4.0%. Such an outlook will make a return to the 2% inflation target difficult. While y/y growth in core PCE prices will continue to fall through 2024, on a quarterly annualized basis we expect the pace to be stuck around 2.5% through 2024. Core PCE prices stabilizing near 2.5% is consistent with CPI stabilizing around 3.0%.

Without the recent emergence of banking sector concerns data would have been pushing for a higher terminal Fed Funds rate than the 5.00-5.25% we expect, and the impact of the banking sector concerns on the economy is highly uncertain. The problem of high inflation is however clear, meaning we believe the Fed is unlikely to be done unless data weakens or banking sector risks escalate. We expect the Fed’s final 25bps move to come in May. By June data may be slowing and financial risks rising, with the debt ceiling standoff likely to be coming to a head by then. However, given that we are not now forecasting a clear recession and are still forecasting a frustratingly slow decline in inflation we do not expect easing to emerge until June of 2024. We expect 75bps of easing in 2024, compared with 150bps in our December outlook. With progress on inflation likely to stall above the 2% target, the Fed is still likely to feel that restrictive policy is still needed. We expect rates to remain above the 2.5% the Fed currently sees as neutral through 2025, though we expect 100bps of easing in that year, leaving the target range at 3.25-3.5% at the end of 2025.

In the long term, a sustained inflation pace on the 2% target will be difficult to achieve in an environment of reduced globalization. Ultimately we believe the Fed will conclude that inflation within 1%, on either side, of its 2% target is acceptable. In hindsight, the Fed’s concern over persistent marginally below target inflation in the pre-pandemic era proved overdone, and may have contributed to the excessive inflation that it is now struggling to control. Worrying about inflation sustaining a marginally above target pace in the post-pandemic era may be similarly inappropriate.

Of the Many Risks, the Debt Ceiling Merits Particular Attention

Uncertainty is high, and not only from the banking sector and ongoing global geopolitical issues, with risks on both sides of growth and inflation. Markets will struggle to interpret surprises in monthly data releases, as it will be unclear whether they are erratic moves or signaling a long-awaited change in trend. Markets have had a tendency to assume the latter when downside surprises are seen and leave themselves vulnerable to disappointment. 

The main risk from domestic politics is a downside one, and potentially a severe one. The debt ceiling will need to be raised by Q3 2023. It looks almost certain that brinksmanship will be taken to the limit, and as in 2011 this will have adverse effects on markets and consequently confidence and the economy. Our central assumption is for a last minute deal that avoids major disruptions to the economy, allowing growth to resume in Q4 after a Q3 when uncertainty is likely to be a factor behind a modest contraction. The risk that brinkmanship will be taken over the edge, risking a default of debt repayments or drastic across the board spending cuts, is however too high for comfort.

Markets seem to be assuming that because the 2011 standoff was resolved, this one will be too. However, the 2011 standoff was resolved by putting in place a plan that if further negotiations could not come to a deal, cuts in non-discretionary spending, both defense and non-defense, would be enforced, and they eventually were. Democrats seem determined not to agree to such a formula this time, while defense spending cuts will face heightened opposition given concerns over Ukraine and China’s rise. Republicans may have backed off asking for cuts to Social Security and Medicare, which are the main source of long-term debt concerns, but may insist on cuts in non-defense discretionary spending, and here recently passed increases are something that few Democrats will be prepared to give up. Meanwhile House Speaker Kevin McCarthy is in a much weaker position than his 2011 counterpart John Boehner, unable to alienate the extremes of his party without risking his position. If Democrats stick to their current position, or offer only token concessions, McCarthy may have to choose between keeping his job and risking worst-case scenarios. By the end of Q2, markets may be taking these worst-case scenarios seriously.