As we inch toward potential recession, we expect the Fed's stronger action to slow hiring and raise unemployment. Under such a scenario, the "cure" for the U.S. economy and jobs market may feel worse than the disease.

Recent indicators show a resilient economy through June, despite rising prices and interest rates--but there appear to be cracks in the foundation. We continue to expect U.S. GDP growth to slow to 2.4% this year, in line with our preliminary May forecast, though 80 bps lower than our March estimate of 3.2%.

As people learned to live with COVID-19 and prove resilient so far to higher prices at the checkout stand, economic momentum will likely protect the U.S economy this year. What's around the bend in 2023 is the bigger worry. Extremely high prices and aggressive rate hikes will weigh on affordability and demand. With the Russia-Ukraine conflict and China slowdown exacerbating supply chains and pricing pressures, it's hard to see the economy walking out of 2023 unscathed.

We now forecast a low-growth recession in 2023. GDP growth will slow to just 1.6%--well below the economy's estimated potential growth rate of around 2.0%--given continued higher prices and borrowing costs as cumulative rate hikes take hold. The unemployment rate will climb 70 bps to 4.3% by the end of 2023, reaching 4.8% by the end of 2024 and over 5% by the end of 2025.

We expect the Fed to continue to frontload rate increases this year and reduce the size of its balance sheet. We expect the federal funds rate to reach 3.00%-3.25% by year-end. Rates will climb to 3.50%-3.75% by the end of 2023 and remain there until the first rate cut in third-quarter 2024 as the Fed waits for inflation to near the 2.0% target, which will occur in second-quarter 2024.

Consumer sentiment fell to an all-time low in the June, according to the University of Michigan. We expect it to languish there as conflict-driven higher prices weigh further on household purchasing power and stock prices weaken as investors move to safe-haven assets. While relatively healthy household balance sheets have helped cushion higher prices at the checkout stand, this buffer is running thin. With purchasing power squeezed, household spending will slow to 3.4% in 2022 and 1.9% in 2023, from its 73-year high of 7.9% in 2021. We believe the pinched purchasing power was already a factor in 2021, given high inflation. The Russia-Ukraine conflict made it worse.

Despite the extreme uncertainty around the conflict, we continue to expect it will remain contained both in intensity and geography. We now expect the military conflict to last longer than we earlier thought, with sanctions to remain in place well after it ends.

Given limited direct trade and capital flow linkages between the U.S. and the region and since domestic activity largely drives our economy, we do not believe the conflict, on its own, will tip the U.S. into recession.

Chart 1

Our baseline reflects a low-growth recession in 2023. However, as growth approaches zero, the economy is more at risk of contracting, leading to a technical recession (where economic growth falls below zero for at least two consecutive quarters). Despite currently healthy U.S. economic momentum, shrinking savings pose risks to the baseline.

Table 1

We increased our assessment of the risk of a technical recession (a broad-based, sharp reduction in economic activity) over the next 12 months to 40%, with a 35%-45% band given heightened uncertainty, from our May forecast of 25%-35%. This reflects continued supply disruptions and a larger spike in prices leading to further Fed action in 2023 that will damage household purchasing power. As households shut their pocketbooks, businesses that built up inventory to meet surging demand will be left with full shelves. The Fed will ultimately get its wish, and businesses will be forced to sell at a discount, bringing down prices (and hurting profit margins).

A False Dawn For The Jobs Market

As markets reel over fears of a looming inflation-induced recession, the jobs market is still acting as if everything is fine. Employers added 390,000 jobs in May. The unemployment rate, at 3.6%, is virtually the same as the pre-pandemic rate of 3.5% in February 2020, which was the lowest since December 1969. Paychecks remained fat in May, with average hourly wages up 0.3% for the month and up 5.2% over last May.

The unemployment rate from the household survey was low for the wrong reasons--353,000 people got jobs and 363,000 left the labor force. The labor force participation rate edged up to 62.3% in May from 62.2% in April, but was below 62.4% in March. An increasingly tight jobs market bodes poorly for labor productivity and growth.

Indeed, labor markets are experiencing their own supply-chain bottlenecks, given that a 45-year low in labor force participation may be creating a bit of a false dawn. However, with vaccinations now available for children five years old and under, we expect more parents will re-enter the market. But with the economy slowing and at risk of tipping into recession, the newly working parents may arrive just as the party is ending.

Still, with a slowing but still-strong economy and pent-up demand, one has to ask--where are the workers?

Labor Force Roll Call

While the jobs reading appears to say otherwise, many people have not returned to the labor market. During the first two months of the pandemic in the U.S. (February-April 2020), the number of people age 16 and up participating in the labor force plunged to a 49-year low by roughly 3.9% or 8.2 million participants--53% of which were women, according to S&P Global Ratings Economics calculations.

While men have returned to the labor force in droves, we calculate that more than 600,000 women are still missing from the labor market. Among prime-age workers (aged 25 to 54), a critical part of the U.S. labor force, 744,000 female workers are still missing, while men of prime age have already surpassed the pre-pandemic peak by 176,000 (see "Labor Force Exit Has The U.S. Economy In A Bind," Nov. 22, 2021).

Chart 2

Comparing current labor force dynamics and pre-crisis trends, conditions look far worse. Between 1948 and 2020, leading up to the pandemic, the U.S. workforce has grown by around 0.1 percentage points per month, according to our calculations. Since the pandemic, average monthly labor force growth has dwindled to less than zero as the retirement pace picked up and younger families avoided the workplace because of the pandemic. Given that the economy has surged since February 2020 while workforce growth has slowed dramatically, we are down 3.9 million workers from the pre-pandemic growth, with women comprising 2.8 million of that shortfall.

It's likely that many women are still dealing with pandemic-related childcare issues. And with many women working in close physical proximity services sectors, such as leisure and hospitality, their absence helps explain the hiring challenges these businesses face.

Along with missing workers, paychecks have shrunk in real (inflation-adjusted) terms. In fact, while total compensation for civilian workers is 1.9% below its pre-pandemic rate of growth, in real terms, total compensation has been drifting lower since March 2021 and is now 3.9% below its pre-pandemic trend.

Chart 3

Chart 4

This is because, while wage gains are at record highs, overall price gains are even higher, with the May Consumer Price Index (CPI) surging by 8.6% year-over-year, a 40-year high. The Fed's preferred inflation indicator, the core Personal Consumption Expenditures (PCE) deflator, at 4.9% in April, is almost 2.5x the Fed's 2.0% target. Based on current inflation expectations hovering at record highs, high prices have, using the Fed's lingo, become 'persistent'.

Consumer Spending: The Affordability Tipping Point

Although higher gasoline prices dent household purchasing power overall, spending on energy as a percentage of disposable income for low-income households is about 5x that of high-income households.

Moreover, the cushion for household balance sheets--thanks to fatter paychecks, hefty stimulus packages in 2020 and 2021 that targeted lower-income households, and high stock prices--is running thin. Indeed, higher borrowing costs and the stock market correction will take a chunk out of their balance sheets. Furthermore, if prices remain high, they will eventually erode all buffers, particularly for those with lower incomes and smaller cushions.

The latest Census Retail Sales numbers are about as we expected, with total May retail sales down 0.9% on a month-over-month basis, and up 0.5% when excluding auto sales. But the 4.0% jump in gasoline store sales explains where the money went. More money spent at the gas pump meant less to spend elsewhere, with sales excluding gasoline stations down a hefty 0.7% in May (see chart 5).

Chart 5

When we adjust the retail sales number for inflation, a frightening split has appeared over the last year, and has only gotten wider. Purchasing power has been squeezed, particularly among low-income households. While savings stored up during the pandemic have enabled households to absorb higher prices, eventually these buffers will whittle down.

Higher Prices And Interest Rates: A Sour Summer Cocktail

Home prices at all-time highs, as indicated by the S&P/Case-Shiller Home Price Index, and the Fed announcing plans to drive interest rates higher this year could leave a sour taste in the mouths of potential homebuyers as we head into the summer season.

Potential buyers have already responded to the double hit of high prices and interest rates. The mortgage applications index fell to 208.20 in the week ended June 3, its lowest level since May 2020, before recovering slightly to 242.8 for the week ended June 17. The index has declined by almost 47 points since the start of the May as supply and now affordability problems weaken activity in the home purchase market.

Thanks to stronger household balance sheets, a hot stock market (until now), low interest rates during the pandemic, and a desire to leave crowded cities, home demand and therefore prices have surged since the second half of 2020. The year-over-year growth rate of the S&P CoreLogic Case-Shiller U.S. National Home Price Index reached a historic high of 20.6% in March 2022, more than 5x the average of 4% in the past five years.

Despite the recent housing boom and slowing housing supply since 2010, mortgage payments have remained under 25% of the average first-time homebuyer's income. Generous government transfers, low interest rates, and a temporary decline in home prices made mortgages even more affordable in 2020. Now, with a more hawkish Fed, we expect this number to rise to 26.5% in the first quarter of 2023, the highest level since second-quarter 2006.

The decision to purchase a home may affect a family's quality of life well before they enter the housing market as potential homeowners save for their down payments. We calculated the amount of time a family needs to save for a 20% down payment for a starter home, assuming a saving rate at the national average. From 2010 to 2019, it took 12 years for a first-time homebuyer to save for a 20% down payment (see chart 7). The length of time dropped in 2020, helped by lower rates and a strong stock market. However, we expect the period to widen well above pre-crisis levels in the next three years--despite a gradual decline starting in 2023 as personal saving rates return to pre-pandemic levels. This will be because of tighter monetary policy, a faster increase in home prices relative to household income, and declining saving rates as inflation depletes household nest eggs.

Chart 6

Chart 7

The Federal Reserve: Cruel To Be Kind

The strong jobs market and rapidly rising inflation gives the Fed more reason to be aggressive, with 75 bps hikes like we saw in June (the first since 1994), possibly becoming the new normal. Given that the Fed is already behind the curve on inflation, baby steps won't work this time.

According to our March downside scenario forecast, a more aggressive Fed policy to combat unbridled inflation would slow GDP growth considerably next year to just 1.4%, while the unemployment rate would be near 4.0%. Unfortunately, our new base case is more pessimistic. We now expect the unemployment rate to top 4.3% by the end of 2023 and reach 5.0% by the end of 2025.

We expect that the Fed raising interest rates and reducing its balance sheet will be enough to eventually begin to tame inflation and help restore real wage strength and purchasing power. The question is whether it will push the U.S. into recession as well.

Table 2