Collateral Damage

Continued high prices through most of next year and the Fed's decision to aggressively raise rates--accepting, in our opinion, the collateral damage to the U.S. economy--are leading households to pull back on spending and businesses to cut costs in response to slowing demand.

With odds that the U.S. economy will avoid recession over the next 12 months dimmed, we continue to expect the U.S. will fall into recession in 2023. We now expect GDP growth to weaken to -0.1% in 2023. Peak-to-trough U.S. GDP will decline by 0.8%, a mild recession in line with the 1969/1970 recession (see table 1).

Table 1

Recent indicators support our view, as rising prices and interest rates eat away at private-sector purchasing power. Indeed, of the leading indicators we track in our Business Cycle Barometer, only one of the nine indicators was in positive territory through October--seven were negative and one was neutral (see "Business Cycle Barometer: Worsening Near-Term Growth Prospects," Oct 24).

Although our 10-year/three-month term spread indicator remained neutral in September, daily readings have been inverted since Oct. 25. Moreover, both the 10-year/one-year and 10-year/two-year have been inverted, on average, for three straight months, which signals a recession. The average 10-year/three-month is headed for an inversion in November, with the average through Nov. 22 at -0.35%. If it's inverted for the second straight month, that would also be a recession signal.

While economic momentum has protected 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 aggregate demand. With the Russia-Ukraine conflict ongoing, tensions over Taiwan escalating, and the China slowdown exacerbating supply-chain and pricing pressures, the U.S. economy appears to be teetering toward recession.

We expect the Fed to frontload more rate increases this year as it continues to reduce the size of its balance sheet. We expect the federal funds rate to reach 5.00%-5.25% by second-quarter 2023 and remain there until the Fed cuts rates in late 2023 on signs prices are stabilizing. Inflation will not approach the Fed's 2.0% target until later in 2024. The fed funds rate does not reach its neutral rate until fourth-quarter 2025.

Chart 1

Table 2

Our expectations for a recession (a broad-based, sharp reduction in economic activity, as defined by the National Bureau of Economic Research) over the next 12 months reflects continued supply disruptions and a larger spike in prices. As a result, the Fed could continue to hike interest rates into mid-2023, damaging 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 of lower inflation, and businesses will be forced to sell at a discount, bringing down prices (and hurting profit margins).

Midterm Elections: Impact On The Economy

With the GOP winning a majority in the House of Representatives--albeit a slim one--the federal government will be divided come January's inaugurations. This result will almost certainly sustain, if not deepen, the acrimony between the two major parties. This is important because a divided government usually reduces any prospects for major changes in economic policies at a time when the U.S. will likely slip into recession. With the majorities slim in both the House (for Republicans) and the Senate (for Democrats), there may be some opportunities for bipartisan agreement between the two sides, as sponsors try to find a member from the opposing party willing to vote against their party. But, passage of major legislation is unlikely.

This would leave the Inflation Reduction Act as the last major policy victory for the White House before the next presidential election, in November 2024. From a broader economic perspective, two years of legislative inaction could be particularly costly.

On the bright side, in September Congress agreed on (and President Biden signed) legislation that will keep the federal government open through Dec. 16. But, if negotiations fail this time, the government will shut down right before the holidays, leaving many offices, museums, and parks closed.

The Job Market's Last Stand

With inflation rampant across most products and a policy-induced recession seemingly on the horizon, the job market remains defiant, refusing to cool down despite Fed actions.

The Bureau of Labor Statistics (BLS) reported U.S. nonfarm payrolls increased by 261,000 in October, much higher than the 200,000 consensus expected. Average hours worked rose by a solid 0.2% for the month, the fourth straight monthly increase, and the average workweek held at 34.5 hours for the fifth straight week, meaning current payrolls are overstretched, suggesting businesses will need to hire more.

Despite aggressive Fed action, the job market remains tight as workers continue to see fatter paychecks, giving people more to spend and push against Fed action. But overall inflation likely outpaced wage gains in October, with purchasing power squeezed by negative real wage gains. Hourly earnings were a robust 0.4% over September, with year-over-year wage gains moderating to a still solid 4.7% increase for the year. However, when adjusted for inflation, wage gains will remain negative for the 19th straight month. Personal income in real terms is now $1.3 trillion lower than its pre-pandemic trend rate (see chart 2). Even so, the huge number of new hires year to date, at 4.1 million, which is twice last decade's annual average, means many more paychecks to spend, with aggregate spending another force for the Fed to reckon with. Overall job gains were even hotter when considering net upward revisions of 29,000 the prior two months.

Chart 2

The unemployment rate rose by 0.2%, to 3.7%, as both more people counted themselves unemployed and more people left the workforce. This rate is still close to its precrisis rate of 3.5% in February 2020, which was a 50-year low. We forecast the unemployment rate will climb 1.3 percentage points to 5.6%, on average, in fourth-quarter 2023, and then moderate to under 5.0% by the end of 2024. The fourth-quarter 2025 unemployment rate is expected to be 1 percentage point higher than its current October rate of 3.7%.

While markets seem sanguine on the BLS report, discussions may be less rosy at the Fed. We believe the October report means the Fed--as it struggles to tame inflation--will need to remain vigilant in tightening monetary policy. We believe another 75-basis-point rate hike for the holidays is still on the table. While the healthy jobs report supports a strong holiday period, it's one that is a little less merry for the Fed as the window for a soft landing closes. We expect the Fed will top 5.0% by mid-2023.

They All Fall Down

Of the nine economic indicators we track in our Business Cycle Barometer, only jobless claims remained in positive territory in September. Six indicators were negative and two were neutral. The term spread indicator, based on the 10-year/three-month curve, was in neutral territory, though it appears to be joining the others that have already inverted.

Our 10-year/three-month term spread indicator has been inverted since Oct. 25. The 10-year/three-month average spread for November, through Nov. 25, hit -0.39% after nearing zero in October, all but ensuring that it has inverted, on average, for the month.

This follows both the 10-year/one-year and 10-year/two-year, which have been inverted, on average, for over four and a half straight months. The sustained inversions of these two spreads signal an impending recession (see "Despite Rising Risks, Yield Curve Is Not Yet Signaling Recession," May 4, 2022).

Keep in mind that an inverted curve is a signal that markets expect the Fed will need to loosen monetary policy in the future. The overarching reason is in response to fears that a slowdown in economic conditions could lead to recession. In other words, an inverted curve reflects market recession fears. Unfortunately, those fears are often right.

With that said, if the average 10-year/three-month remains inverted for two straight months (we look for a second month to confirm the first month), it is then considered a recession signal. But regardless of the preferred indicator, historically, through 2020, when any two of the four spreads invert for at least five months, a recession occurred within the next 12 months. This is a threshold that the 10-year/one-year and 10-year/two-year curves are about to cross.

The continued high prices through most of next year and the Fed's aggressive rate hikes, leading to households and businesses pulling back on spending and investment, further support our view.

Considering Upside And Downside Growth Scenarios

While S&P Global Ratings Economics sees a shallow U.S. recession in its baseline forecast, in such an uncertain environment, we also consider the U.S. economic outlook in a scenario of faster growth than the baseline and one with slower growth.

Most pressing is the timing and pace of U.S. monetary policy, as the Fed tackles inflation, which has remained high on continued supply-chain disruptions.

In a possible downside scenario, U.S. inflation remains high on continued supply-chain disruptions emanating from the Russia-Ukraine conflict and China's zero-tolerance policy on COVID-19. Still behind the curve, the Fed ramps up policy tightening through 2023 as U.S. economic activity falls further into the red.

In a possible upside scenario, supply chains stabilize sooner than expected, helped by an easing of quarantine measures in China. Although highly uncertain, one can't ignore the possibility of a faster resolution to the Russian-Ukraine conflict. On softening inflation as supply chains stabilize, the Fed is able to slow monetary tightening, reducing U.S. borrowing costs to elevate affordability concerns for the private sector. The Fed's wish comes true, and it manages a softer landing for the U.S. economy in 2023.

Table 3