Cooler days ahead for the US economy as cost fatigue, surging interest rates and slower employment growth take their toll on consumer and business activity
- Outlook: The US economy continued to show remarkable resilience over the summer, with surprisingly robust job growth and an unexpected consumer spending spree that likely propelled real GDP growth above 5% annualized in Q3. While these signs of economic strength will likely fuel speculations that the economy is reaccelerating, we do not expect such strong momentum will be sustained. The recent rapid tightening of financial conditions spurred by surging bond yields represents a material headwind for business investment and consumer spending. With a myriad of headwinds persisting, including tighter credit conditions, the restart of student loan payments, uncertainty regarding the lagged impact of monetary policy and a fragile global economic backdrop, real GDP growth is likely to drift below trend for several quarters. We foresee real GDP growing a muted 1.4% in 2024 following expected growth of 2.4% in 2023.
- Labor market cooling: The September jobs report had a pleasant scent of non-inflationary growth with a strong 336k payroll gain but gently moderating wage growth to 4.2% year over year (y/y). While we continue to expect further hiring restraint and strategic resizing decisions along with continued moderation in nominal wage growth, we don’t anticipate a severe employment pullback. We foresee the unemployment rate rising toward 4.0% by year-end and rising to around 4.4% by the end of 2024.
- Don’t bet against the US consumer … in the summer: The strong retail sales performance in September and upward revisions to the prior month’s figures point to notable consumer spending enthusiasm over the summer. While consumer spending likely grew more than 4% annualized in Q3, momentum is likely to downshift significantly in Q4, as increasing pressure from elevated inflation, higher interest rates, slowing labor market gains and the restart of student loan repayments lead to more spending scrutiny. We project that consumer spending will grow 2.2% in 2023 and around 1.2% in 2024.
- Bumpy, but downward-sloping disinflationary road: While the summer rebound in energy prices led to a modest bounce in headline inflation, disinflationary tailwinds remain strong for core inflation. Headline CPI inflation remained flat in September at 3.7% y/y, while core CPI inflation moderated 0.2 percentage points (ppt) to 4.1% — its slowest pace since September 2021. Factoring lower gas prices in October and ongoing disinflationary pressures from reduced housing rents, lower profit margins, easing wage growth and restrictive monetary policy, we believe the last inflation mile will not be the most difficult. Barring adverse geopolitical developments in the Middle East, headline CPI inflation will likely close the year around 3.2% y/y in December and core inflation around 3.7%.
- Higher for longer: The recent string of positive economic surprises will keep the Federal Reserve on high inflation alert, and although it won’t tilt the Federal Open Market Committee (FOMC) toward another rate hike at the November meeting, the December meeting will very much remain a “live” one. The recent barrage of Fed communication indicates policymakers’ focus is shifting from “how high” to raise the policy rate to “how long” to maintain it at restrictive levels. As such, we reiterate our belief that Fed officials are increasingly comfortable with the idea that the tightening cycle is complete. Still, we do not foresee the Fed cutting interest rates before mid-2024, and the process will likely be very gradual.
- Risks: Labor market and consumer resilience along with stronger productivity growth are undoubtedly the main upside risks to the economy. Paradoxically, inflationary growth could prompt the Fed to overtighten monetary policy, which could lead to a rapid and disorderly tightening of financial conditions. In turn, this would raise the risks of pronounced recession. Globally, the Israel-Hamas war has emerged as a key downside risk as an escalation of the conflict could significantly weigh on the global economy, with a spike in oil prices and sharp tightening of financial conditions.