US economy: rays of hope?

14 November 2022

Henk Potts, London UK, Market Strategist EMEA

  • While the US economy – like many in the developed world – has had something of a subdued year, the outlook points to a slightly brighter future compared to many of its peers
  • The US economy is still expected to slow in 2023 before recovering as the year progresses. The pace of any slowdown will be dictated by the strength of the labour market, resilience of consumers, inflation trajectory and the path of monetary policy
  • The US Federal Reserve seems set to stay aggressive on rate hikes for now. But once inflationary pressures ease, the central bank is likely to take its foot off the gas as the US resumes on its growth path 
  • As such, we forecast 2023 to be a year of slow growth for America but not recession

Aggressive rate hikes, plus commodity and food price shocks, have rocked American consumers and businesses. However, as the central bank finally takes its foot off the interest rate accelerator and inflationary pressures ease, the country appears set to grow faster than most developed-world peers next year.  

Whether the economic slowdown seen in the US this year was a recession or not is open to debate. The National Bureau of Economic Research (NBER) defines one as being a significant decline in economic activity spread across the economy, lasting more than few months, normally visible in production, employment, real income, and other indicators.  

While the dip in US output may not have met this broad definition and growth rebounded in the third quarter, the two consecutive quarters of negative growth registered in the first half of 2022 are, at least, testament to an uneven downturn.  

Economy takes foot off accelerator

The weakness in the US economy has been driven by decreases in inventory and housing investment, lower levels of government spending, and a reduction in net exports. Additionally, construction, wholesale trade, and manufacturing activity have shrunk in recent months.  

September’s Institute for Supply Management (ISM) survey showed that manufacturing (12% of the economy) activity grew at its slowest pace in more than two years1. While, the services purchasing managers index (PMI) continues to point to an expansion, growth rates have been slowing due to a decrease in business activity and new order orders.  

The strength of the labour market, resilience of the consumer, inflation trajectory, and the path of monetary policy will be the key factors in determining how much the economy slows in 2023.  

Tight US labour market to slacken

The American unemployment rate fell to 3.5%2 in September, the lowest level since the 1970s, although the headline rate is also a reflection of a lower participation rate. As the economy weakens over the coming year, we would expect job creation levels to reduce and the unemployment rate to begin to rise. A fall in non-farm payroll creation and job openings was seen in August, hitting the lowest since June 2021.  

We forecast that the US unemployment rate will rise to around 4.9% at the end of next year, and average 4.5% in 2023 (see table). While obviously higher than today, it is not at a level that will scare policymakers.

US consumers to  keep spending

Consumer spending has proved to be resilient, despite pressure on real incomes. Personal consumption expenditure (the value of the good and services purchased by, or on behalf of, US residents) rose 0.4% in August. Spending has remained positive as consumers rotated from buying goods into services, a trend that is likely to persist next year. 

Helpfully, demand should continue to be cushioned by rising wages, a lower saving rate, and excess consumer savings built up during the pandemic.

Confidence fragile

Consumers are ending the year not as glum as they were in the summer, supported by lower petrol prices and a buoyant labour market. However, confidence about the future continues to be fragile. The University of Michigan’s survey showed that the consumer expectations component has declined due to renewed pressures from uncertainty over the future trajectory of prices, rates, economies, and financial markets. 

Given the clear stress on purchasing power and confidence levels, together with the forecasted moderate increase in unemployment, we expect private consumption growth to materially weaken through the course of next year. For 2023, we expect household demand growth of 0.4%, much less than the 3.5% increase this year. 

Is a house price slump on the cards?

The US housing market looks set to come under much pressure next year. After a post-pandemic boom, prices are now registering monthly declines, as the market adjusts to elevated prices and soaring mortgage rates.  

The average 30-year fixed loan has surged above 6.9% in recent weeks, its highest level since 2002. Applications to purchase or refinance a home fell to their lowest level since 1997 in October, according to data from the Mortgage Bankers Association3. We expect price appreciation to continue to ease next year, and possibly turn negative as sales slow and affordability measures become stretched. 

Impact of a split on the economy

The midterm elections failed to produce the “Red Wave” that Republicans had hoped for on 8 November, as the Democrats outperformed the opinion polls leaving control of Congress hanging in the balance, at the time of writing. 

While Republicans appear to have taken back control of the House of Representatives, the lack of a governing majority suggests that the US administration will now move into a period of legislative gridlock.  

The diffusion of power across the political spectrum will likely constrain rule makers to deciding upon the appropriate levels of government funding and assessing expiring provisions. Divided government means that President Biden will have to decide to either move to the centre and try to find compromise with the GOP leadership or try to impose policy changes through executive actions and regulatory changes.

Inflation should moderate

October’s inflation report offered some encouraging evidence that prices pressures are finally starting to ease. The annual consumer price index (CPI) fell from 8.2% in September to 7.7% in October, the slowest rate of increase in 2022. Core inflation, which excludes volatile components like food and energy, also decelerated to 6.3%, compared to the 40-year high of 6.6% in September.

We anticipate that the rate of price increases will further decline in 2023, supported by a broad-based slowing of demand, high inventory accumulation, and easing supply constraints. Nonetheless, the upside risks from shelter, tight labour markets, and elevated wage inflation, together with the uncertainties on food and energy prices, make it difficult to quantify the pace of disinflation.

We believe that the peak in inflation is now behind us and that it will slowly grind lower over the next twelve months. We expect headline CPI of 6.8% year-on-year in December, before gliding to 2.5% at the end of 2023. Similarly, core CPI is forecast to be 6% at the end of the year, before slipping to 2.9% in December 2023. 

Hiking cycle to go out with a bang

The lowest unemployment rate in five decades, coupled with the highest inflation readings in 40-years, have forced the US Federal Reserve (Fed) to push ahead with its steepest tightening cycle since the 1980s, despite evidence of a significant economic slowdown. 

The resilience of labour markets and the persistence of inflation suggests that the central bank will need to deliver an extended finish to its policy normalisation programme. We expect the Fed to raise rates by a further 50 basis points (bp) at the December and February meetings. 

We would then anticipate that the Federal Open Markets Committee (FOMC) will step down to a final 25bp increase in March, as risks between inflation and growth begin to level out. (see chart). This suggests that the terminal point for the fed funds rate for this cycle will be 5–5.25%.

But, rate cuts on the way

The easing of inflation expectations, concerns about the impact of tightening financial conditions, and slowing growth could finally see the Fed pivot back to an easing stance towards the end of 2023. We have pencilled in 25bp cuts at the final three meetings of 2023, suggesting that the target range for fed funds would finish next year at 4.25-4.5%. 

A year of slow growth, but not recession

Looking forward, it is likely to be a subdued year for the US economy, although the outlook looks brighter compared to its European counterparts. We expect activity to contract somewhat in the first three quarters, before recovering in the final three months of the year. Our forecast is for real GDP to decline by just 0.1% in 2023, compared to growth of 1.8% in 2022.

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