The U.S. economy appears on track for 2.5% average growth this year, spurred by a sturdy labor market--repeating last year's outperformance versus peers. However, the average growth forecast gives an overly positive outlook of the economy. A strong handoff from last year--with 3.1% annual growth in fourth-quarter 2023--masks the forecasted gradual slowdown to 1.8% by fourth-quarter 2024 (see chart 1).

A recession in the next 12 months appears less likely now than it did in the spring of last year. But factors that supported rising demand through 2023--especially consumer spending and direct government outlays--are likely to fade over time, while the impact of restrictive monetary policy on the economy will limit fixed business investment and residential investment. Net exports will likely revert to neutral to negative for growth after they surprisingly added a large 0.6 percentage points to growth last year (see chart 2).

Chart 1

Chart 2

Stock building is poised to add almost 50 bps to our 2024 baseline growth forecast. Inventories appear relatively low once again as businesses have been hit by tight bank lending (much of the working capital that finances inventories comes through banks' commercial and industrial loans). Even as businesses remain cautious about inventory management, it's likely that the contractionary effect on inventories from overall tight credit will be more than offset by a relatively low inventory-to-sales ratio. Nevertheless, we note that stock building is the most uncertain component of contribution to growth since the forecast is hard to pin down.

We continue to expect the economy to transition to below-potential growth as the year progresses. The weaker growth will cause demand for labor to slacken further, which will likely lead to a gradual uptick in the unemployment rate over the next two years, from 3.9% currently to 4.3% by the end of 2025 (consensus estimates of the longer-run steady state are clustered around 4.0%-4.4%).

Inflation Forecast Points To A First Rate Cut In The Summer

Resilient domestic demand and seasonal quirks in the beginning of the year stymied the sequential declines in inflation that occurred June-December. That said, we think disinflation will continue, albeit on a bumpy path. We forecast core inflation (excluding volatile energy and food prices) on a monthly sequential basis will finally settle closer to the Fed's target of 2.0% on a sustained basis in the second quarter, down from 2.9% over the last six months, as measured by the personal consumption expenditures (PCE) index.

After the upside inflation surprise the last two months, the Fed, which has become increasingly data dependent, is looking for further signs of cooling inflation before making the first rate cut. Given the calendar quirks, we don't think it would have enough data to be fully confident to cut in June. (Specifically, the May CPI and PPI reports, which hint at PCE inflation out later in June, are scheduled on the same day and one day after the final day of the June FOMC meeting, respectively.)

We now think that July is likely the better timing for a first rate cut. (By comparison, the futures market is pricing in a first cut in June.) The risk to this assessment is that the Fed may further delay easing, especially if inflation fails to come down significantly in the next two to three months. The strength of the American economy has given the Fed the option to be patient as inflation moves toward the 2% target.

Our base case assumes a sharper easing of 125 bps in 2025 (versus the Fed's median of 75 bps). This is consistent with our forecast of a sharper growth slowdown to 1.5% in fourth-quarter 2025 from fourth-quarter 2024 (versus the Fed's 2% forecast) and inflation at 2%.

In his post-meeting press conference in March, Chair Jerome Powell revealed that, although no final decision has been made, the "general sense" on the FOMC was to begin slowing the pace of the balance sheet runoff "fairly soon." We think the Fed will announce in May that it will begin slowing the pace of balance sheet runoff beginning in June.

The thinking behind starting to taper the pace of quantitative easing sooner than later is that ideally this would enable individual banks to tackle reserve shortages before they affect the entire system and, thus, potentially get to a smaller Fed balance sheet position (albeit taking longer).

Table 1

Consumer Spending Is Likely To Recover Slightly But Come In Lower Than Previous Years

Consumer spending is growing at a 2.0% annualized pace in the first quarter, according to the Atlanta Fed's GDPNow estimate, down from 3.0% the quarter before. Overall, we expect a moderation in spending this year--to 2.1% in the fourth quarter versus 2.7% in the fourth quarter last year. And for 2025, we forecast 1.9% annual average consumer spending growth, the lowest in the last 10 years excluding 2020 (when the pandemic curtailed activity).

We believe the slowdown in the first two months of the year somewhat overstates the near-term pullback in consumption. We anticipate some recovery in March consumer spending. Households, on aggregate, are still benefiting from a few factors that together should remain supportive of spending in the near term:

• Real income tailwind (with inflation moderating below income growth),
• Relatively low interest-coverage pressure (helped by an effective mortgage rate locked in at below 4% for many), and
• High net worth (represented by elevated home prices, rising equity prices, and relatively high fixed-income interest income).

Still, households are likely to become more cautious toward spending over time. Higher interest rates led to a sharp rise in debt-service burdens on consumer credit, the non-mortgage portion of household debt (see chart 3). That burden will rise further in 2024 as debt-servicing payments resumed on student debt owed to the government in the fourth quarter of 2023. The stock of accumulated excess saving from the pandemic-era has been largely run down.

Growing vulnerability to higher interest costs is showing in delinquency rates on credit cards and autos that have surpassed pre-pandemic levels (see chart 4). The relatively high stock of household wealth is unevenly distributed, possibly giving a false sense of comfort to the aggregate data.

Chart 3

Chart 4

Fixed Investment Is Finding Growth

Nonresidential

The growth contribution from nonresidential fixed investment, or business fixed investment (approximately 15% of GDP), has moderated through the current monetary policy hiking cycle, though it remained positive in 2023, adding a little more than 0.6 percentage points to GDP growth. We expect the growth contribution from business fixed investment to fall further in 2024, contributing half as much as it did last year. If not for some factors that offset the effects of high interest rates, this channel's contribution to growth would likely have been lower.

Chart 5

Chart 6

Business fixed investment consists of three components: nonresidential structures (approximately 20%), traditional equipment (40%), and intellectual property (40%). (Intellectual property [IP] and tech-related outlays fall into the last two categories.) At a high level, all are interest rate and credit sensitive, although IP outlays less so than more traditional spending.

In the nonresidential structures component, the outlook for commercial construction, especially, has been dampened by the tightening in bank lending to this sector, with deteriorating CRE-office market fundamentals. Nonresidential commercial construction looks to be pulling back, which we expect will weigh on overall outlays in the years ahead.

That said, manufacturing project spending should remain solid given the support of federal spending packages such as the CHIPS and Science Act, even as it looks poised to moderate further in growth. Education and health care structures spending are also potential growth areas, as existing buildings undergo further updates and expansions. For oil and gas structures, rig count has inched up in recent weeks, but new drilling activity remains weak, which portends a slow pace of energy-related outlays ahead.

As for the equipment and IP components, we have lifted our forecast slightly on the premise that recent investment in manufacturing facilities begins to translate to increased equipment spending and production. We continue to believe capital expenditure is bottoming out this year, in tandem with our assumption that the Fed is likely to start easing monetary policy.

Residential

On the residential side of private investment, homebuilding activity has two subsectors--single family and multifamily--at different points in the cycle. Single-family groundbreaking was up 35%, while multifamily (mostly rental) was down 35% year over year in February. Permits--a leading indicator of starts--point to single family continuing its rise while multifamily appears to have now come down to near pre-pandemic normal rates. We anticipate the accumulated surplus of units under construction to put a lid on further growth, for the time being, in the multifamily segment.

Builders continue to tap into buyer demand, which remains relatively strong, despite affordability issues, while the supply of existing homes in the resale market remains low. Although volatile, mortgage purchase applications have generally risen during the first three months of this year, which suggests a stronger pace of home sales in the months ahead. Looking forward, building activity should remain a slight positive this year compared with 2022 and 2023 as stable employment and less restrictive financing costs bring more buyers into the market.

Labor Market's Resilience And The Upside From Immigration

We have lifted our estimates for 2024 job growth in response to higher economic growth, and we now look for payrolls to expand at more than a 100,000 monthly rate through the third quarter (see chart 7). Starting in the fourth quarter, weaker sequential GDP growth will start to bite payroll gains. The unemployment rate will drift higher in the next two years (see chart 8), from the 3.8% average during most of this year to 4.3% by the end of 2025 (the longer-run steady-state consensus estimate is 4.0%-4.4%).

Chart 7

Chart 8

Labor supply and demand have come into better balance. Overall layoffs remain relatively muted, as initial unemployment claims suggest. Measures of labor market churn have also normalized: Layoffs, the quit rate, the hiring rate, the labor participation rate, and the ratio of job openings to unemployed workers (removing the effects of trends) are now near or at 2018-2019 levels.

That said, there are also signs of ongoing softening. Jobs growth is increasingly dependent on acyclic sectors such as the public sector and health care. The percentage of small businesses that are planning to hire is back down to its 2017 level, according to a survey by the National Federation of Independent Business. And employment in the temporary help services sector, a tried-and-tested leading indicator of the labor market, was down 7% in January from a year before.

Last year, rebounds in the labor participation rate and immigration levels to pre-pandemic norms eased the severe labor market imbalance that we saw in 2022. We think the labor participation rate will continue to edge up this year while more people come off the sidelines and into the labor force. But beyond this year, we anticipate the labor participation rate moving lower as baby boomers continue to retire.

But some upside risk exists. In fact, net immigration in 2023 was approximately 2 million above what was projected earlier, as suggested by a new estimate of population growth from the Congressional Budget Office (CBO) and an analytical piece on immigration published by Wendy Edelberg and Tara Watson at The Hamilton Project in March (see chart 9). The additional people engaged in both production and consumption in the U.S. partly explain the surprising strength in consumer spending, labor force growth, and overall economic growth since 2022.

Using the new CBO estimates of net immigration released in January 2024, The Hamilton Project report estimated that the labor market in 2023 could have sustainably accommodated employment growth of 160,000-230,000. That is still below the actual monthly increases in employment in 2023, but far less so than previously estimated.

Similarly, for 2024 they estimate sustainable employment growth will be 160,000-200,000, approximately double the sustainable level that would have occurred in absence of the pickup in immigration according to the projections from the Census. According to these estimates, growth of nearly 200,000 workers is actually not a hot labor market.

If immigration levels remain high in 2024, as CBO expects, our employment growth, participation rate, and economic activity forecasts will likely benefit. The boost will be also relevant for the long-term potential of the economy.

Chart 9

Chart 10

Path Of Inflation Remains The Story For The Fed

In its latest policy meeting, the Federal Reserve Open Market Committee (FOMC) maintained the federal funds rate at 5.25%-5.50% and announced it would continue its balance sheet runoff at the current pace.

The Fed's Summary of Economic Projections in March was updated from December (see table 2).

Table 2

The updates are consistent with the upgrade to economic growth, the January-February inflation hiccup, and the expectation that inflation is more likely to remain elevated over the coming year. It turns out that firmer-than-expected inflation in the first two months of the year hasn't derailed the central bank's plans for rate cuts.

At the moment, the economy's resilience has given the Fed the option to be patient in cutting rates. The hotter inflation readings the first two months of the year caused market pricing to push the timing of the first rate cut from March to the June/July time period. While we agree with this timing, it will require the economy to show some signs of slowing and for inflation to reestablish its downward march to 2%.

Despite uneven progress so far, we think there will be more disinflation in services in 2024 (see more in "U.S. Economic Forecast Update: A Sturdy Job Market Keeps Growth Going," Feb. 21, 2024). Still-falling goods prices, albeit modestly from here on, will enable more of an adjustment to relative prices without services prices needing to rise. And stable inflation expectations will prevent increases in goods and services prices.

Core services--excluding housing, which is more closely associated with the labor market--should see continued disinflation given the moderation of wage growth pressures, the normalization of companies' price-setting behavior (frequency of price changes), and anchored inflation expectations.

Noneconomic factors are also at play. Inflation in medical prices (including drug pricing) in the PCE index will remain cool because of effective government price controls. And the price of shelter, another large part of the index, should moderate in coming months given the lagged effects of rents leveling off through 2023. To this point, whether rent inflation will moderate quickly enough in the government data to bring the aggregate core PCE inflation close to 2% is a key risk on the timing of Fed's rate cut.

Chart 11

Our baseline view is that some combination of housing services, core-services excluding housing, and core goods inflation will get us to inflation near 2% in sequential terms by midyear. However, there is a risk that it may take longer since the initial benefits of normalizing supply conditions are behind us and since consumer demand isn't wilting away as fast as previously expected. The lack of a new negative output gap cautions against expecting much more downside in cyclically sensitive goods prices. Continued gains in real income support consumer spending, but stronger demand risks interrupting the decline in inflation.

At the same time, supply-side forces (such as increasing labor productivity) could reverse, and disruptions from conflicts around the world (between Israel and Hamas and between Russia and Ukraine) could reignite inflation.

Table 3

Risks To Our Baseline Forecast

The risks to our baseline growth forecast are nearly balanced. Based on ordinary risks surrounding our baseline forecast, our pessimistic scenario has milder consumer spending and business investment growth in 2024 (see table 4). In our optimistic scenario, the slowdown is shallower, and the unemployment rise starts later and is smaller than in our baseline (see table 5).

The key uncertainty in our baseline forecast is the timing of a business cycle slowdown, which, admittedly, has been very difficult to pin down. We believe that we will see an adjustment to below-potential growth in the coming quarters, but the conviction on the timing of its arrival is low.

Table 4

Table 5