S&P Global Ratings expects the U.S. economy to slip below trend for a drawn-out period. While we now expect the economy to expand 2.3% this year (up from 1.7% in our June forecast), we see growth slowing to 1.3% in 2024 and 1.4% in 2025, before converging to trend-like growth of 1.8% in 2026. We expect the unemployment rate to rise to 4.8% in 2025, above the longer-run steady state of 4.0%-4.5%. We continue to forecast core inflation finally falling closer to 2.0% by this time next year (see table 1 for forecast highlights and table 2 for extended baseline forecasts).

We now expect the Fed to hike the policy rate another 25 basis points (bps) in its November meeting. Although the Fed left its key policy rate on hold at 5.375% (mid-range) in its September meeting, the accompanying summary of economic projections had a hawkish-rate tilt. Most notably, the potential for rate cuts was trimmed for next year as the new year-end median rate outlook of 19 Federal Open Market Committee members was left at 5.6% in 2023, raised to 5.1% (from 4.6%) in 2024, increased to 3.9% (from 3.4%) in 2025, and set for 2.9% for 2026.

The medians imply only two quarter-point rate cuts in 2024, though five small ones in 2025 and additional four in 2026. The change stemmed from the upward revisions to growth forecasts and downward revisions to the unemployment rate (and a small change to the inflation forecast), with little cost to employment despite higher implied real rates (at 1.5%-2.5%) for the next two years.

Our baseline forecast is one of an ever-elusive "soft landing" occurring, but we are not as optimistic as the Fed (some have called the Fed's outlook a "perfect" landing scenario). We expect the real economy to be considerably weaker next year and inflation closer to target in the second half, which will persuade the Fed to cut rates more aggressively than what it has penciled in--with rates likely landing at 4.4% and 2.6% by the end of 2024 and 2025, respectively.

Table 1

Recent Developments

U.S. economic data has been coming in stronger than expected, suggesting that an ever-elusive "soft landing" could occur. Second-quarter GDP growth of 2.1% annualized will likely be revised upward (closer to 2.4%) in its third estimate, which the Bureau of Economic Analysis plans to publish later this week. Also, our preferred running estimates are pointing to 3.5%-plus growth in the third quarter, given the strength in consumer spending and pace of inventory accumulation.

Chart 1

Activity in the service sector, led by leisure and travel, continued to outshine the goods-producing sector. Federal legislation signed in 2021 and 2022 is also having a substantially positive impact on U.S. GDP growth. The CHIPS and Science Act and the Inflation Reduction Act have spurred non-residential fixed investment via tax credits and loan guarantees. Private-sector expansion of manufacturing capacity--specifically designed to produce semiconductors, electric vehicle batteries, and other electronics in the U.S.--has far exceeded expectations. Public-sector spending on infrastructure is also bolstering growth thanks to funds appropriated for the next 10 years through the Infrastructure Investment and Jobs Act.

Chart 2

Chart 3

At the same time, the imbalance between demand and supply in the labor market has been gradually diminishing. Payroll employment growth has moderated, with the three-month average payroll jobs growth for August coming in at 150,000, which is below the 2018-2019 average. Still, this pace is robust, given population growth and the low unemployment rate. Layoffs have diminished since May, with the four-week moving average of initial claims at 217,000 in the week of Sept. 16.

Average hourly wage growth--at 4.3% year over year--remains elevated for the Fed's liking, especially considering the inflation target of 2% and productivity growth. But some of the pressure may be waning as job vacancy rates have fallen steadily and voluntary quit rates have eased to the pre-pandemic level. As demand moderated, the supply of workers increased more than expected. The labor force participation rate ticked up 0.2 percentage points to 62.8% in August, which caused the unemployment rate to edge up to 3.8% from 3.5% in July, despite a healthy jobs gain.

Consumer price inflation, although still elevated, continued to show signs of easing. That said, the honeymoon period from the base effects is now over. As a reminder that the last mile of disinflation is going to be bumpy, headline CPI inflation bounced back to 3.7% in August from 3.2% in July, mostly because of the recent rise in energy prices. The West Texas Intermediate has climbed roughly 14% since mid-August, increasing the likelihood for energy prices to rise again in September.

Excluding energy and food, core CPI inflation slipped to 4.4% from 4.7%. Core consumer prices have been at a 2.4% annualized rate for the past three months, which is the slowest pace since March 2021 and consistent with the Fed's target. Declines in headline inflation are now helping to stabilize or improve household real disposable incomes.

Chart 4

Chart 5

Financial conditions, as indicated by the 10-year Treasury yield and 30-year fixed mortgage rate, have tightened since August after a brief period of loosening. Both interest rates have now climbed back past last fall's peak.

Still, the prevalence of fixed-rate debt in the U.S. economy has meant sharp interest-rate hikes in the last 18 months have had less damaging effect than they might have in the past. According to Capital Economics, an economic consulting firm, the adjustable-rate share of newly issued mortgages has fallen from an average of 40% in the 1980s, and 25% in the 1990s and 2000s, to less than 15% in the past decade. A similar shift is evident for corporate debt, with floating-rate debt accounting for only 15% of corporate bond issuance in recent years.

The greater share of fixed-rate debt helps explain why the huge rise in market interest rates during the past 18 months hasn't yet had any significant impact on debt servicing costs. With many borrowers taking the opportunity to lock in record-low rates 2011-2021, the average effective interest rate on outstanding mortgage debt has barely budged since the Fed began hiking its policy rate, and remains close to a record low.

Chart 6

Forecast Update

GDP growth

Better-than-expected growth so far (especially in the third quarter) led us to revise up our U.S. GDP forecast for 2023 by 0.5 percentage points to 2.3%. That said, we do not think the current momentum is sustainable. We think the economy is approaching an inflection point where many special influences are now behind us (the Taylor Swift and Beyonce tours are winding down, pandemic-related excess savings have depleted).

We expect the growth pace to slow sharply in the final quarter of this year and through most of next year. The third-quarter strength is likely not to get carried over in the final quarter of the year as interest rates on the 10-year Treasury note and 30-year mortgage have recently risen to 4.5% and 7.2%, respectively, values not seen since before the global financial crisis of 2008. We have also revised upward our forecasts for these important financial variables, with the cumulative tightening effect offsetting the unexpected uptick in momentum.

The resumption of student-loan payments is a drag on consumer spending, albeit a modest one. We assume the impact from a government shutdown to be a wash, since it is likely to be resolved in the same quarter. We assume a continuing resolution (temporary spending bills) will be passed with the proverbial can kicked down the road for negotiations on budget resolution for another day (December, perhaps).

Still, in the process of getting another spending resolution done, it is likely that there will be additional compromises over discretionary spending initiatives. We also assume that the United Auto Workers' (UAW) strike, which has a net negative effect on GDP growth in the ongoing quarter (and a reversal in the same quarter or the next one, depending on the timing of resolution), will be resolved early in the fourth quarter, having minimal damage to baseline GDP growth.

More generally, the pent-up demand on services (leisure and travel, for example) is poised to fade next year, and we remain wary of the monetary-policy lags--especially over time as more debt needs to be refinanced, while also continuing to weigh on demand for new loans. We forecast 1.3% growth in 2024, which is unchanged from our previous forecast, but that overstates the fourth-quarter over fourth-quarter growth of 1.1%, which is a 0.4-percentage-point downward revision (resulting from the base effects in annual average versus fourth-quarter over fourth-quarter calculations). Our forecasts for 2025 and 2026 were little changed.

Chart 7

The bottom line is that the current expansion is in its late cycle, as indicated by the positive output gap. Any further short-run cyclical boost to growth is limited by the economy's underlying growth potential. The principal leading indicators give mixed signals for near-term growth prospects, and the current expansion is likely to enter a period of slower-than-trend growth in the coming quarters. We forecast the business-cycle adjustment at below-trend growth (less than 1.8%) in the next 12-18 months.

Unemployment and inflation

A delay in growth slowdown by a quarter has led us to push back the timing of the rising unemployment rate as well. Given the usual lags from GDP growth to labor market, we don't expect a significant deterioration of today's labor markets until early 2024. Layoffs remain low currently, but signs of weakening demand can be seen in the sharp decline in payrolls for temporary services. With growth slowing below trend after 2023, we project the unemployment rate to rise to 4.8% by 2025 before reversing course toward the longer-run sustainable rate of 4.0%-4.5%.

Chart 8

We made a small downward revision to our inflation forecast. Still, the last mile of disinflation is going to be bumpy, no doubt. The disinflationary impulse was better than we had anticipated in the last three months (despite the sharper uptick in August).

Energy prices have jumped recently, which, if sustained, have a way of permeating into core prices. This is a risk to our baseline inflation forecast. The production halt of cars, albeit temporary, is likely going to delay the disinflationary impulse from the used cars and new car component (in turn, auto insurance and maintenance) but not for long. Shelter price inflation (the largest component in CPI) should decline sharply in coming quarters, reflecting a recent pause in rent increases. Moreover, any surge in energy prices that boosts year-over-year inflation in the fourth quarter of 2023 could cut it in 2024 if, as is typical, the energy-price surge proves temporary.

Chart 9

We expect core CPI inflation to fall below 3% only next year and not get comfortably near the Fed's inflation target before the fourth quarter of next year.

Market pricing of future Fed hikes has moved materially since our last report and is now consistent with rates staying high for longer. Forward pricing now sees the Fed Funds rate at 5.25%-5.50% through second quarter of 2024, taking the previously anticipated rate cuts in the first quarter off the table. In other words, a "Fed put" is no longer seen as a likely scenario. What the market is not pricing in, however, is another rate hike. We agree that the policy interest rate appears to be, at or close to, a peak. We anticipate one more rate hike in November, but monetary stance will continue to tighten in real terms, peaking in the second quarter of next year (see chart 10).

Chart 10

Table 2

Risks To Our Baseline Forecast

The balance of risks to our baseline growth forecast is tilted to the downside. Based on ordinary risks for our baseline forecast, our pessimistic scenario has mild recession-like dynamics in 2024, while in our optimistic scenario, the slowdown is shallower and the unemployment rise starts later in 2024.

Pessimistic scenario

In a possible pessimistic scenario, the current upturn in energy prices persists long enough to slow down the disinflationary momentum. In turn, the Fed feels compelled to raise policy rates higher than in our baseline scenario, and markets are forced to adjust to a more restrictive monetary outlook. Such a tighter monetary stance could cause a deeper output drop response from interest rate-sensitive sectors and private investment more broadly.

Growth would stall in the first half of 2024 and pick up only gradually afterward, even as the Fed rushes to cut rates once it sees accelerating layoffs and weaker demand reigniting disinflationary forces. In this scenario, GDP would still end up eking out 1% growth for the full year.

Both residential and nonresidential investment would be weaker for the forecast horizon, as would payrolls, raising the unemployment rate (peaking at 5.2% versus 4.8% in the baseline) and consequently, weakening demand growth versus our baseline. Inflation, although higher in the first half of next year, would move drop sharply as near-recessionary winds ensue. 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.

Table 3

Optimistic scenario

It is also possible that the economy will fare better than in our baseline. In one such scenario, the current strength of the U.S. economy dissipates slower than our baseline case. The slowdown is delayed by a year and nowhere near as drawn out as in the baseline.

Even though pandemic-related excess savings have been depleted as conventional estimates suggest, the money spent is still income to others, moving around the economy (if it hasn't been extinguished as debt repayment). That continues to grease the wheels of consumers and businesses alike for another couple of quarters into next year. In this scenario, in 2024, consumers still show some fire-power left in their wallets, as jobs remain plentiful. The unemployment rate dips further down to 3.3%. Continuing disinflation makes households richer in real terms. The Fed raises rates by one extra 25 bps versus our base case.

While annual average GDP growth comes in at 1.7%, fourth quarter over fourth quarter growth is still an underwhelming 1.3% (due to what economist call the "carry-over" effect). The cumulative effect of rate hikes starts taking effect in earnest in the second half of 2024 and in 2025, as some business cycle purging in the private sector starts to take place, but it is far from anything stringent like in the past.

The lack of excess leverage in the household sector that historically sets the economy into a tailspin during high interest-rate periods puts a floor on any kind of slowdown, together with the past government initiatives via the CHIPS and Science Act and the Inflation Reduction Act, still leaving their countercyclical mark on business investments for green energy and semiconductor facilities. In addition, new infrastructure funds from Washington and healthy state finances leave combined government investment spending growth positive.

Table 4