US 2023 Outlook: The Economic Costs of Curbing Inflation

We continue to believe the economy is in the early stages of recession

Economic growth momentum continues to rapidly wane, and we believe the economy is in the early stages of entering a recession as of Q4 2022. The housing market downturn has accelerated as home sales and prices are now both falling rapidly. The industrial sector appears close behind, due to a series of synchronized negative shocks including a stronger dollar, collapsing external growth, saturated domestic goods markets and higher interest rates.

More broadly, a number of key economic indicators used for dating recessions by the National Bureau of Economic Research (NBER) have begun to soften. Faltering business confidence, tightening lending standards and waning loan demand will all likely weigh on business investment across both structures and equipment. Rates-sensitive consumption has started to slow, including in autos, despite pent-up demand acting as a modest buffer.

In 2023, we expect the domestic economic slowdown to broaden and intensify as the Fed remains aggressive, financial conditions tighten further, the labor market weakens and consumers pull back more meaningfully on spending. Service consumption has benefited from a gradual rotation away from goods, but that modest tailwind will likely falter as job losses start in early 2023. Excess savings and state-level transfer payments have likely underpinned spending, but support from both factors is unlikely to be sustained. In addition, momentum for COVID-sensitive services has continued to trend lower in recent months, consistent with widespread weakness across major service business surveys.

We continue to believe the initial pullback in economic activity will be relatively mild, in part reflecting strong initial conditions for households relative to previous downturns. However, monetary and fiscal policy headwinds into the downturn – in contrast with the historical reaction function and reflecting the unusual nature of the current macroeconomic environment – will likely prolong the recession. In many ways, we believe the upcoming recession will be a function of the Fed’s efforts to return trend inflation to 2% sustainably.

Altogether, we expect real GDP growth of -0.5% y-o-y and +0.1% y-o-y in 2023-24 (-1.1% and +0.9% Q4/Q4), respectively. We expect five consecutive quarters of economic contraction from Q4 2022-Q4 2023, followed by an only-muted recovery.

Labor markets in 2023 – the elephant in the room

Exceptionally tight labor markets remain inconsistent with the Fed’s 2% inflation objectives, in our view. In 2023, we believe the focus will shift to how quickly labor market momentum continues to soften, including the timing and duration of job losses, along with the ultimate destination of the unemployment rate in this cycle. It is also important to see how quickly wage growth will decelerate as non-housing core service prices, a key inflation metric, is considered as being closely tied to wage growth.

At the moment, labor markets remain strong, but forward-looking indicators have begun to soften. Monthly job gains in cyclically sensitive industries have slowed notably, continuing jobless claims are steadily rising, the Conference Board’s labor market differential has eased from recent highs, and gross hires and quits have started to move lower as firms and workers become more cautious.

In terms of ordering, we expect an initial slowdown in hiring – the easiest lever for most firms to pull – before reductions in job openings and outright layoffs. Layoffs remain concentrated in the tech sector, but we expect headcount reductions to soon spread to construction and manufacturing (reflecting challenges in the housing and industrial sectors, respectively) before broadening to the service economy in 2023. Labor hoarding during the pandemic recovery, in an environment of severe labor shortages, could result in a discontinuous increase in layoffs once firms shift their expectations to a persistent contraction in economy activity. Altogether, we expect the unemployment rate to rise to close to 6% by end-2023, where it will likely stay through 2024.

A soft landing is possible, but remains unlikely

For the economy to achieve a soft landing – inflation moving lower without a recession – we believe a few factors will be required, all of which have shown scant evidence of coming to fruition.

First, the easing of labor market tightness would need to come overwhelmingly from declining job openings as opposed to rising unemployment. Second, a more sustained recovery in labor force participation (labor supply) would likely be required to ease wage pressures without a meaningful increase in the unemployment rate. However, in recent months, the labor force participation rate (LFPR) has stable around its 2022 average, and underlying data suggest the preponderance of workers that have not returned relative to pre-pandemic levels are retirees, who show few signs of returning to the labor force.

Third, the national inflation conversation will likely need to dramatically improve. However, similar to labor supply, the percent of workers hearing “bad news” about high prices, and the percent of small businesses reporting inflation as their “single most important problem,” have shown few signs of improving. Persistent inflation attention from households and businesses, all else being equal, risks keeping inflation expectations elevated and, we believe, requires a more forceful Fed response.

Risks to the economic outlook

Considering our below-consensus economic outlook, we see a few upside risks to growth. Specifically, moderating inflation – led by the goods sector – could result in stronger real wage growth. That said, weak labor productivity growth in recent quarters suggests a prolonged period of strong real wage growth is unlikely.

In addition, we assume the impact of excess savings on consumer spending will continue to gradually diminish, but a more prolonged boost to consumption is possible. Finally, if long-term interest rates fall faster than we assume, it could result in an earlier boost to interest-rate sensitive consumption, particularly housing.

On the downside, the depth of the recession will likely be proportional to how entrenched inflation proves to be. Persistently high or more entrenched inflation could result in an even more aggressive Fed response, resulting in a deeper contraction. Moreover, while financial conditions have tightened in a relatively orderly way so far, an abrupt repricing of risk could result in a nonlinear response, particularly in corporate credit markets, which could result in a deeper recession.

Goods price disinflation is finally taking hold, but services remain problematic

After accelerating at a brisk clip, inflation has finally started to show signs of moderation. In particular, there is growing evidence of easing pressures on goods prices as supply chains continue to normalize. For example, shorter supplier lead times and the lagged impact of a stronger US dollar are now more clearly weighing on import prices. In addition, shipping costs have moderated, and retailers’ inventories have been replenished.

However, the main driver of inflation has been shifting toward core services, which tend to be sticky and more closely tied to labor markets. We expect a tug of war between lowering goods prices and persistently high service inflation to continue during the first few months of 2023. That said, considering goods prices are volatile and prone to external shocks, we believe service prices – and hence labor markets – are a more important determinant of trend underlying inflation.

The outlook for core services inflation

In terms of m-o-m core PCE inflation, which is the most relevant inflation metric for the near-term monetary policy outlook, we decompose core PCE service prices into three groups: rent/owners’ equivalent rent (OER), healthcare services and other services as those groups appear to follow different price dynamics.

For rent/OER inflation, our modal forecast suggests m-o-m rent inflation will likely start to decelerate sometime in Q1 2023, based on the historical lead-lag relationship between the official and private rent data.

Healthcare service prices – accounting for more than 15% of the core PCE price index – will likely become increasingly important for the near-term monetary policy outlook. Specifically, Medicare’s payments for outpatient hospital care are updated in January each year based on “market baskets” of goods and services that medical providers purchase, suggesting we will likely see the lagged impact of past wages and goods price inflation on Medicare hospital prices in early 2023.

We think that core service inflation excluding rent-related components and healthcare is closely correlated with wage growth and as the economy slows, we expect this component to moderate gradually. We have already seen some signs of decelerating wage growth, supporting our view that core service inflation excluding rent/OER and healthcare will moderate substantially in 2023. Overall, we expect y-o-y core PCE inflation to reach 2% by the end of this year.

Risks and uncertainty around our inflation outlook

That said, there is a great deal of uncertainty and risks around our inflation outlook. Goods prices could easily become inflationary forces considering increasing vulnerability of supply chains to external shocks such as geopolitics, de-globalization and climate change.

There is the possibility of underestimating overarching macro factors. Specifically, persistently strong wage inflation despite some cracks in labor markets indicates the risk of a wage-price spiral. Recent labor disputes in certain industries underscore that concern as the cost of living might be starting to become entrenched in the wage-setting process.

A discovery process for the Fed’s reaction function in early 2023

2022 was characterized by the most rapid rate hiking cycle in modern memory as Fed participants sought to catch up with persistently elevated and increasingly entrenched inflation. With the Committee downshifting to a 50bp rate hike in December, policymakers are now beginning discussions regarding the necessary criteria for both slowing the pace of rate hikes further, and eventually pausing. Chair Powell’s comments at the December FOMC press conference suggest a preference for slowing to 25bp hikes in February as the FOMC seeks to ascertain the appropriate level of restrictive rates

In our modal outlook, we assume Fed participants remain focused on the trend of realized m-o-m core PCE inflation and relevant trend inflation measures such as the median and trimmed-mean PCE to determine when to stop raising rates, continuing hikes until the underlying trend of m-o-m core PCE inflation drops below 0.3%. Accounting for our inflation forecast, we believe this will result in 25bp hikes in February and March to a terminal rate of 4.75-5.00% despite our recession expectations.

The threshold for rate cuts and our expectations

Tying together our recession expectations, the labor market outlook and inflation forecast, we believe m-o-m core PCE inflation will drop below 2% on an annualized basis starting around mid-2023. Against that backdrop, with the economy mired in recession and an unemployment rate quickly approaching 6%, we expect Fed participants to begin cutting rates gradually by 25bp per meeting starting in September. The slower initial pace of rate cuts will likely be motivated by concerns of a rebound in inflation, but if it becomes clear core PCE inflation will undershoot the Fed’s 2% target in 2024, we expect the pace of rate cuts to accelerate to 50bp per meeting in Q2 that year.

Similar to the reaction function for pausing rate hikes, we see elevated uncertainty over how the Fed will respond to eventually cutting rates. Almost all Fed participants remain reluctant to publicly consider rate cuts in 2023, likely for fear of easing financial conditions undoing their work to tighten this year. Moreover, while participants and the Fed staff have become more pessimistic about avoiding a recession, most participants still suggest their modal outlook includes sub-trend but positive real GDP growth. Once a recession becomes clear, and inflation underperforms, participants will likely coalesce over a gradual initial pace of cuts, especially considering that as inflation falls, the Fed’s policy rate will mechanically become more restrictive in real terms.

Financial conditions, financial stability and volatility

Financial conditions have tightened notably in 2022 as the Fed’s hawkish pivot took hold. In 2023, we expect ongoing tightening – including further declines in equity prices, wider corporate credit spreads and increased difficulty in small business access to credit – as the Fed raises rates further and holds them at a restrictive level despite an ongoing recession. Once inflation starts to persistently underperform in mid-2023, and the Fed signals rate cuts are likely, financial conditions may ease somewhat, but the initially slow pace of easing could limit any positive impulse.

The Fed and political pressure in 2023

We believe the Fed in 2023 will come under some of the most intense political pressure it has faced since the 1980s. Already, some members of Congress have sought to discourage the Fed from further rate increases due to concerns over the labor market. While the White House has largely maintained its distance and continues to promote Fed independence, the criticism from Congress will likely intensify next year as job losses start. Powell’s hawkish comments so far have been easier to maintain in an environment with historically low unemployment rates, but that will likely become more difficult once the labor market deteriorates. His semi-annual testimony before Congress in February will likely be contentious.

That said, we do not believe the Fed will respond meaningfully to political pressure. Powell and other Fed participants have been clear that long-run labor market health depends on low and stable inflation, and we also believe Powell has become conscious of how history will view him in a high-inflation environment. Repeated emphasis on former Chair Volcker’s experience suggests a lower likelihood he will settle for a persistently higher level of inflation without first going through an economic downturn.

The outlook for fiscal policy

A return to divided government in 2023 – Republicans and Democrats holding very narrow majorities in the House of Representatives and Senate, respectively – will likely usher in a period of elevated fiscal policy volatility and close the door on meaningful fiscal stimulus during the latter part of our expected recession.

Similar to monetary policy, we believe divided government in 2023 will result in a lack of fiscal support during the economic downturn. Republicans face few incentives to provide cooperation ahead of a pivotal 2024 presidential election, especially in an environment where many politicians continue to debate just how much of current unwanted inflation stems from excess pandemic fiscal support, and how effective additional fiscal support would be in a high-inflation environment. All else being equal, the lack of fiscal support will likely mean a longer-than-average downturn.

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