US Weekly Economic Commentary: Stubborn inflation clouds the outlook

Recent data revealing stronger-than-expected readings on the labor market, manufacturing production, and consumer spending continue to suggest that the US economy is not yet in recession, and that the odds of recession beginning in the first half of 2023 have receded somewhat over the last few weeks.

While GDP growth in the fourth quarter was revised down 0.2 percentage point to a still robust and above trend 2.7% (annual rate), we raised our tracking forecast for first-quarter growth from -0.5% to -0.3% last week.

Nevertheless, with inflation remaining stubbornly and unacceptably high, the recent and prospective worsening in financial conditions that is likely to come from additional Fed tightening may still tip the US into recession in coming quarters. Since early last year, the Fed has boosted the Federal funds rate target range by 4½ percentage points, with the goal of tightening the entire complex of financial conditions to slow growth in economy-wide spending.

A progressive slowing in growth has occurred in real final sales to private domestic purchasers, arguably the best measure of domestic aggregate demand. The four-quarter percent change slipped from 6.4% in 2021 to just 0.9% as of the fourth quarter of last year, and the one-quarter annualized precent change in fourth quarter 2022 was a scant 0.1%.

Such slowing patterns of growth are seen broadly across components of GDP, including personal consumption expenditures (PCE), although last week's report that real PCE jumped 1.1% (monthly rate) in January bucked that trend.

Slowing demand, persistent inflation

Meanwhile, sharp declines in housing construction subtracted 1.3 percentage points from GDP growth over the second half of last year. A recent upturn in mortgage rates has resulted in the Mortgage Bankers' Association purchase index for new mortgage applications plunging 18% in the most recent week to the lowest level since 1995.

Despite such slowing in domestic final demand, there is little evidence that the exceptional tightness in labor markets is easing, and inflation broadly remains stubbornly high. Following the blockbuster employment report for January showing payroll gains of 517 thousand, initial claims for unemployment insurance continue to bounce along cycle lows, and continuing claims, which had been slowly edging higher, fell in the latest week.

Revised data for the fourth quarter showed core PCE inflation at 4.3% (annual rate), much less of a slowing than indicated in the advance estimate. Importantly, core PCE prices jumped 0.6% in January (7.1% annual rate) and the 12-month change edged up to 4.7%. This raises the question of whether the expected and much-hoped-for disinflation has stalled.

No rest for the Fed

This would be concerning enough to Federal Reserve policy makers, but an easing in financial conditions — a rebound in equities, decline in yields and spreads and a sagging dollar — since last fall has undermined the transmission of policy actions to demand and inflation. That has encouraged several Fed officials to suggest that there is "still much more work to do" to bring demand in better balance with supply and reduce inflation back to the 2% target.

It has encouraged us to revise our expectation for Fed policy to now expect three more quarter-point rate hikes that will take the top of the target range for the federal funds rate to 5½% by midyear. The latest readings on inflation and underlying strength in spending and income suggest upside risks to this revised interest rate forecast and increase the odds of a 50-basis-point increase at one of the next few meetings of the Federal Open Market Committee.

Markets are getting the message that the Fed is likely to push rates higher than previously anticipated as yields and spreads have risen and equity prices have edged lower in recent weeks, a trend that gained momentum last week.

This week's economic releases:

• Nominal goods deficit (Feb. 28): We estimate the nominal goods deficit widened in January by $5.8 billion to $95.5 billion in January.
• Construction (March 1): We estimate nominal construction spending rose 0.5% in January. This would reverse a 0.4% decline in December and would reflect unseasonably mild temperatures in January, following unseasonably cool temperatures in December.
• Consumer confidence level (Feb. 28): We estimate the Conference Board Consumer Confidence Index rose 1.5 points to 108.6 during February as lower inflation provides some relief to consumers.
• Light vehicle sales (March 2): We estimate light vehicle sales slipped in February to an annual rate of 13.9 million units, compared with 15.7 million units in January. Sales in January likely were boosted by mild temperatures and by issues surrounding seasonal adjustment.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.