Resilience Reigns

The pace of U.S. activity remains robust overall, with some mixed signals. First-quarter GDP growth came in below trend at 1.3% annualized but looks likely to be revised higher. Moreover, this headline number is deceptively low since it reflects a negative two-percentage-point contribution from inventory drawdowns. Final sales to domestic purchasers rose 3.3% annualized in the first quarter. Services consumption remained strong and goods production picked up as well. Fixed investment was flat, but the recent sharp decline in residential investment moderated. Recent data suggest ongoing strength in the consumer sectors, and second-quarter GDP is tracking close to 2.0% annualized.

The labor market remains tight, although some cracks are emerging (see chart 1). In May, 339,000 jobs were created, well above consensus, with a relatively strong breadth of hiring by industry and only two industries shedding jobs. However, the unemployment rate rose to 3.7%, while the participation rate was broadly unchanged. A gradual decline in the quit rate and the ratio of job vacancies to job seekers--now both well off their recent peaks--suggest that some tightness in the labor market is starting to unwind.

Weekly jobless claims have returned to more normal levels and are slightly higher than the average seen in the two years before the pandemic, after a low in late September of last year. The layoffs announced by Challenger, Gray and Christmas, an alternative to government data, are trending well above the pre-pandemic normal levels--pointing to some emerging weakness in labor demand.

Chart 1

Inflation remains well above target and uncomfortably sticky, but at least headline inflation has begun to decline. May data showed a 4.0% increase in prices over the past year (down from 4.9% in April), the lowest rate in two years. Energy and new car prices are now declining while the recent surge in used car prices should also reverse as indicated by the Manheim Index. Core CPI (excluding food and fuel) edged lower to 5.3% over the past year and increased 0.4% in May.

The Fed's preferred inflation measure--based on the personal consumption expenditure (PCE) index--actually increased in April (see chart 2). Overall inflation was 4.4% annually as of April, and 4.7% for the core basket, both higher than in March. Sequential or momentum core PCE inflation has been rangebound, suggesting a strong move to the downside is not yet in the cards. However, the so-called "super core" measure (which excludes housing services) is now trending at just 3.0%. Importantly, PCE services inflation is running at 6.6% annually with the shelter component (33% of CPI) yet to make meaningful deceleration.

Chart 2

The Fed held its policy rate steady in June, ending a streak of 10 consecutive increases. This pause was telegraphed and widely expected and kept the Fed Funds rate to a range of 5.00%-5.25%. In its statement the Fed noted that the banking system remains sound, and that the Federal Open Market Committee (FOMC) remains highly attentive to inflation risks. Surprisingly, the updated "dot plots" show that two more 25-basis-point rate hikes are likely in store this year, and that cuts during 2024 will be gradual.

Market pricing of future Fed hikes has moved materially since our last report and is now consistent with rates staying higher for longer. Forward pricing now sees the Fed Funds rate at over 5.0% at the end of 2023, taking the previously anticipated rate cuts off the table. In other words, a "Fed put" is no longer seen as a likely scenario.

Neither the March financial turbulence nor the May debt ceiling showdown moved the macro needle. The Fed has noted that the U.S. banking system, in addition to being sound, is "resilient." The April Senior Loan Officer Survey shows some evidence of tighter lending conditions with concerns about the extension of credit from smaller and regional banks that are more focused on real estate and employment-heavy sectors. Also, the Treasury's financial stress index has eased steadily in the past two months and is now at its lowest level since the pre-Silicon Valley Bank default, as volatility has declined and equity prices have risen.

Revised Forecast: A Shallower But More Protracted Slowdown

In light of the economic resilience, our baseline scenario has a shallower and more attenuated slowdown than previously. Importantly, our baseline U.S. forecast no longer contains a recession. Real GDP growth will slow to under 1.0% in the second half of the year, half the rate expected in the second quarter, amid a material and broad-based decline in domestic demand growth (which will average just over 0.5% growth in the period).

Consumer spending and nonresidential construction will drive the slowdown, while residential construction appears to be bottoming out. Unemployment will drift up toward 4.0% in the fourth quarter. Export and import growth will both decline (the latter more than the former) as global and U.S. demand slows.

Sticky inflation reflecting persistent demand will drive this narrative. While headline CPI inflation has begun to decline sharply as fuel price increases from last year drop out of the data, lowering core inflation will remain a challenge. We forecast headline CPI inflation to drop to around 3.0% by year end, but core CPI inflation will remain closer to 4.0%, twice the target rate. As inflation declines and policy and market rates remain elevated, real interest rates will rise. This will help to lower demand, tighten monetary conditions, and bring down future inflation.

The tightness of financial conditions and the negative impact on growth will peak in late 2023 and early 2024, and we think the pace of recovery will be gradual. Annual GDP growth will not return to trend until 2025-2026. In the interim, domestic demand growth will pick up steadily led by consumer spending, equipment spending, and residential construction. Unemployment will rise to around 4.5%, which we view as compatible with price stability (or 2.0% trend inflation). Core inflation will fall below 3.0% in late 2024 and move toward the target in the outer years, bringing down mortgage rates and Treasury yields.

Table 1

The balance of risks to our baseline growth forecast are tilted to the downside. Higher policy rates could cause a larger negative output response from interest rate-sensitive sectors. If the Fed were to boost rates by an extra 25 basis points in mid-2023 and keep rates higher for longer, both residential and nonresidential investment would be weaker for the forecast horizon, as would payrolls, leading to a higher unemployment rate and therefore, weaker demand growth. Slower inflation would result as the economy moves to a lower output path, closing the output gap sooner. A broad-based slowdown of this nature combined with weak employment would likely resemble the 2001 recession (as classified by the National Bureau of Economic Research).

Land We Must: Resiliency Means Higher Rates For Longer

The U.S. economy continues its resilient pattern of the past few quarters. This despite sharp rises in policy rates and standard recession indicators--such as an inverted yield curve--signaling an imminent, material slowdown since the second half of last year. This resilience has led some commentators to say that maybe the U.S. economy doesn't need to land at all.

We disagree. Quite simply, the U.S. economy must land since it is on an unsustainable path. Inflation remains too high, and unemployment is too low from a price stability perspective. This combination is the result of an economy that is running too hot or, to put it more precisely, an economy that is running above potential with a positive output gap. In order to close the gap, growth needs to spend some time below its potential rate of around 2.0%. This can be achieved with a short, sharp decline (a recession) or a longer period of below potential (a longer landing). But land we must.

Our baseline view is that we see this necessary slowdown as a longer, gradual process rather than a short, abrupt one. An eventual slowdown is necessary and we see a multi-quarter period of sub-potential growth ahead. Under this view, monetary policy rates will be higher for longer and financial conditions will be tighter for longer, easing back toward their longer-term levels as the economy lands.

Appendix

Table 2