US economic outlook: the Fed watches and waits

The US economy continues to grow, with strength in consumption and an unrelenting labor market absorbing the brunt of tighter monetary policy. Still, we maintain our view that expansion will turn into a mild recession in 2H23 and forecast that full-year real GDP growth will average 0.9%, and 0.8% in 2024. We see CPI inflation averaging 4.0% this year before moderating to 2.8% next year, supporting our expectation of 150bps Fed rate cuts starting in 1Q24. This would bring the policy rate down to 3.625% by end 2024 from 5.125% this year, and 10-year Treasury yield down to an expected 3.0% next year.

• We continue to expect a mild downturn in the US economy in H2 as tighter credit conditions and the lagged impact of restrictive monetary policy becomes more apparent.
• While the timing is uncertain, we believe a recession will be necessary to sustainably rebalance labor supply with demand and reduce wage growth.
• We believe it is too soon to declare an end to the rate hiking cycle, even though encouraging inflation dynamics enabled the Fed to take a step back from a raise in June.
• Labor market tightness remains key for our outlook. Signs of moderation in data suggest the labor market will likely continue to weaken in 2H23.

At this week's June decision day, the Federal Reserve (Fed) "skipped" an increase in policy rates for the first time in 15 months. However, Chair Powell reiterated that more tightening may be necessary to restore price stability, a sentiment echoed by the revised "dot-plot" showing a median expectation of two more interest rate hikes before the end of 2023. While real GDP growth and inflation numbers have been revised higher, and unemployment lower, we read the latest Fed communication as a wait-and-see approach that may ultimately forego further interest rate increases over the coming months as price pressures show more apparent signs of moderation.

Table 1: Key US economic forecasts

Headline CPI inflation continued its downtrend in May, easing to 4.0% with assistance from further disinflation in energy and food prices. Importantly, core CPI inflation also crept lower, although only marginally by 0.2 percentage points (ppt) to 5.3%. Core goods inflation fell modestly 0.1 ppt to 2.0% despite a second consecutive 4.4% increase in used car prices. The latter is unlikely to persist, suggesting goods disinflation is likely to continue. As such, we remain focused on the path ahead for service sector inflation, which showed some encouraging signs. Shelter inflation eased to 8.0% in May from 8.1% in April and an 8.2% peak in March. Stripping out shelter, core services fell sharply by 1.0 ppt to 4.2%, its lowest reading since January 2022.

We anticipate that further moderation in core services dynamics will support average headline CPI inflation of 4.0% this year and 2.8% in 2024 and a return to the 2% target is unlikely until some point next year at the earliest. This will maintain upside risk of further rate hikes in 2H23, but we expect the narrowing breadth of inflation sub-components (with 45% now growing by more than 5% in annual terms vs 65% in 2022, see Figure 1) will provide sufficient to keep the Fed on hold at 5.125%.  We see the 10-year Treasury yield 3.4% at year-end, falling to 3.0% by year-end 2024.

Figure 1: Breadth of US CPI inflation

The May 2023 non-farm payrolls showed a reacceleration in labor demand, with employment rising 339 000 and the three-month average of job gains up to 283 000. Job openings also rose 358 000 in April, lifting the vacancies-to-jobless ratio up to 1.8. Still, broader employment data suggest the labor market has turned: unemployment rose to a seven-month high of 3.7% as labor supply increased by 130 000. Participation overall is still below pre-pandemic, but the prime-age participation rate rose to 83.4%, the highest since May 2002. Wage growth is slowing, with average hourly earnings up just 0.3% last month (April: 0.4%) and annual wage growth easing to 4.3%, well below the post-pandemic peak of 5.9% in March 2022. Finally, the quits rate, which reflects workers voluntarily quitting jobs (likely for higher wages), was 2.4%, its lowest since February 2021. Though further weakening is still needed, we see enough moderation in the data to suggest that the labor market will continue to weaken in H2.

A robust economy so far this year lowers the probability of recession, but we still see a mild recession as likely in H2 as tighter lending standards and credit availability fully pass through to the real economy. More than USD 400 billion of government debt issuance is planned for the next three months, to refill the Treasury General Account post-the national debt limit increase.¹ Money market funds are key buyers and have so far drawn down balances at the Fed's ON-RRP² to do so, but if they also draw down bank reserves it may deplete bank liquidity positions and create a bigger economic squeeze. US consumers also remain under pressure. Though real consumer spending rose by a firm 0.5% in April, starting Q2 strongly after personal consumption rose by a robust 3.8% annualized in Q1 2023, the savings rate fell to a four-month low of 4.1% as households used cash buffers for purchases. We estimate US excess savings at c. USD 1.3 trillion, but the lower-income 50% of consumers will likely deplete excess savings in H2 2023. The Conference Board's sentiment index is historically weak, at 71.5 in May 2023 versus a 50-year average of 90 (see Figure 2).

Figure 2: The Conference Board consumer expectations index relative to 50-year average