Nuanced optimism and realism
Outlook: General labor market resilience, moderating inflation and gently slowing final demand growth offer hope of an economic soft landing. With headline inflation cooling rapidly, real wage growth is turning positive providing a tailwind to consumer spending. Simultaneously, the need to address supply shortages across the economy has supported robust construction activity, prevented a severe manufacturing pullback, and helped price and wage pressures ease. Still, the economy continues to face significant headwinds from persistently elevated prices and costs, tightening credit conditions, and rising interest rates. Union strikes, student loan repayments and corporate debt vulnerabilities also represent downside risks. Overall, we see real GDP growing 1.6% in 2023 and expanding at a muted 0.7% pace in 2024, with recession odds around 50%.
Labor market rebalancing: Labor demand has continued to gradually cool, with job growth slowing to 209,000 in June — the weakest pace since December 2020. Declining job openings and a continued rebound in labor supply point to gently easing labor tightness and wage pressures. This is corroborated by our conversations with business executives who report taking a more conservative approach toward hiring and pay. We foresee further hiring freezes and strategic resizing decisions along with some wage growth compression in the coming months, but we don’t anticipate a severe employment pullback. We expect the unemployment rate will rise from 3.6% toward 4.1% by year-end and around 4.5% in 2024.
Consumer tailwinds and headwinds: Consumers are still willing to spend, but they have become increasingly cautious and selective with their outlays amid still-high prices and tougher financing conditions. This has translated into much slower consumer spending momentum after a strong start to the year. We expect a notable downshift in consumer spending growth in Q2 to around 1% annualized, following growth of 4.2% in Q1. With employment expected to moderate further, the disposable income tailwind from slower inflation will be largely offset, and the slowdown in consumer spending will accelerate as the buffer from excess savings shrinks, student loan repayments restart, credit conditions remain tight and household finances deteriorate. We anticipate consumer spending will advance a modest 1.9% in 2023 and register muted growth of 0.8% in 2024.
Slower disinflation is coming: The latest Consumer Price Index (CPI) reading showed a significant easing in inflation, with consumer price inflation falling one percentage point (ppt) to 3.0% year over year (y/y) — its lowest since March 2021. Core CPI inflation fell 0.5ppt to 4.8% y/y and is now 1.8ppt below its September 2022 peak. Easing demand for goods and services, the pass-through from softer housing price inflation and cooling wage growth should lead to continued disinflation into 2024. Yet, with base effects (i.e., favorable comparisons with last year’s elevated food and energy prices) subsiding, headline CPI inflation will likely rebound modestly in coming months before easing back down toward 3% by year-end. Core CPI inflation, meanwhile, is likely to ease toward 4% in late summer and settle around 3.7% y/y in December.
A final July Fed hike: The Fed maintained the federal funds rate range unchanged at 5.00%–5.25% at its June policy meeting and signaled two more rate increases this year as officials remain concerned about core inflation being too high relative to the 2% target. Given our softer growth and inflation outlook, we anticipate the Fed will raise interest rates only once more in July before holding rates steady throughout the remainder of the year as it assesses the impact of tightening to date on the economy and inflation. While we do not anticipate rate cuts in 2023, we foresee the Fed starting to discuss policy recalibration in the winter, highlighting that, with inflation cooling, it will consider slowing cutting nominal interest rates to maintain real rates steady. The first rate cut is unlikely before March 2024, and we anticipate about 100bps of rate cuts through 2024.