The United States: Mild but sluggish recession as tight Fed policy bites

The US economy is decelerating under the weight of rapid rate hikes. Inflation will fall back to the Federal Reserve target by the end of our forecast period. But the mild recession we expect will not be enough to persuade the Fed to declare victory, as long as the labour market remains strong, and consumption resilient. It will raise its key rate in one more step early this year. Cuts will not begin until late 2023 and the key rate will stay above the Fed’s estimated neutral rate for the rest of the period.

Increased hopes of a soft landing.

Stronger growth in the second half of 2022 and moderate year-end inflation data have reinforced hopes of a soft landing. We expect GDP growth of 2 per cent last year (Q4 results will be published on January 26): a bit above our November forecast. The easing of inflation will support private consumption as real incomes again rise. Meanwhile aggressive Fed hikes will continue to impact interest rate-sensitive parts of the economy. Household resilience will weaken as previous savings buffers are depleted. We still foresee a dip in GDP this year, but we expect this to occur later and be a little milder than previously projected. We have raised our 2023 forecast to 0.5 per cent (0.1 per cent in November’s Nordic Outlook Update) but lowered our 2024 forecast to 1.2 per cent (November: 1.5 per cent). One reason is that we expect the Fed to proceed cautiously with rate cuts.

Key data

Year-on-year percentage change

*% of labour force **% of GDP ***Upper end of the Fed's ­range.                     
Source: Macrobond, SEB

Greater pessimism in the business sector

Late in 2022, manufacturing sentiment fell to levels that signal a marked slowdown in industrial production. Weak international conditions and a strong US dollar are reflected in falling order estimates. Previous support from large order backlogs has faded, and actual production fell in November. Meanwhile improved supply chains and falling input prices have reduced cost pressures, supporting expectations of a continued decline in goods inflation. Last year the service sector regained ground it had lost during the pandemic, but service sector sentiment fell steeply late in 2022 to slightly contractive levels. Small businesses remain pessimistic and have begun to scale back hiring plans, while earlier labour shortages have eased somewhat.

Reforms will soften the downturn in capital spending.

Business investments, excluding construction, have been uneven this past year. Order bookings for capital goods, excluding defence and aircrafts, are pointing towards a slowdown ahead. This will be partly offset by the Biden administration’s push for investments in infrastructure, domestic semiconductor production and climate, although phased in over a lengthy period (see theme article, page 20). Total capital spending is expected to fall by about 2.0 per cent in 2023, mainly due to the construction sector, but rebound in 2024.

Reduction in savings rescued consumption

During 2022, households maintained their consumption despite falling real incomes by tapping into the large financial buffers built up during the pandemic. According to the Fed, these buffers peaked at around 10 per cent of GDP (USD 2.3 trillion) during the third quarter of 2021 and then fell by about one fourth by mid-2022. This suggests that households still have significant reserves. But according to the Fed, most of these savings were held by households in the upper half of the income distribution, which suggests that the remaining buffers are unlikely to be fully spent. The savings ratio, as a share of disposable monthly income, levelled off late last year at its lowest levels since before the global financial crisis, at just over 2 per cent. Meanwhile falling asset prices have eroded total household financial assets, which are back at pre-pandemic levels as a percentage of GDP.

Uncertain outlook as consumption forces shift.

This year, households will benefit from rebounding real incomes as inflation slows, but they will probably be more cautious about drawing down savings as the labour market starts to weaken. Auto purchases seem to have been especially hard hit by supply-side problems but are also more sensitive to interest rates. In 2022 fiscal policy tightened sharply as large pandemic stimulus programmes ended but will be more neutral this year. Upcoming negotiations over the debt ceiling, where Republicans are expected to demand sharp spending cuts, are a downside risk for the next couple of years, however. We expect private consumption to grow at a moderate pace of around 1 per cent in both years, down from nearly 3 per cent last year.

Rate-sensitive housing market.

Thirty-year mortgage rates appear to have peaked. Sales of existing homes may thus bottom out soon, having fallen nearly to the lowest levels that were recorded during the pandemic, and before that in 2010. We expect residential construction to keep falling during the first half of 2023, along with home prices. Spill-over effects to the rest of the economy will still be limited, compared to the 2007-2008 housing crash. This is mainly because variable rate loans account for a very low share of household debt, which is also moderate as a share of incomes. Housing-related spending for electronics and appliances has fallen steadily since last spring, though not dramatically. Yet the number of employees in the construction sector has unexpectedly kept growing.

Hot labour market, especially for low-paid

Last year the labour market was characterised by shortages, rapid job growth and historically low unemployment. Labour force participation has stagnated since early 2022, amplifying these imbalances. In this setting, the employment cost index (ECI) has risen at its fastest pace since the early 1980s. Newly acquired bargaining power, especially among low-paid workers, has led to narrowing pay inequities. Some groups have seen their real wages rise since the start of the pandemic.

Equilibrium unemployment in focus for the Fed.

The number of job vacancies still indicates a historically tight labour market. The ratio between vacancies and unemployment (the Beveridge curve) suggests worse matching after the pandemic. If this persists, the jobless rate may need to be pushed up well above the 4 per cent that the Fed today regards as an equilibrium level. But a better balance can also be achieved without increased layoffs. The fact that the vacancy rate has begun to fall in an otherwise strong labour market indicates an opportunity to follow the steepest part of the old Beveridge curve (the stylised pink curve in the above chart), rather than the post-pandemic curve (the green curve). Such a development would open the way for the soft landing that the market is hoping for, but which the Fed does not yet dare to confirm.

Moderate rise in unemployment.

Unemployment fell in December to 3.5 per cent – matching the pre-pandemic 50-year low. Job growth has started to decelerate, but in December it was still higher than its pre-pandemic average (180,000) and well above the 100,000 that the Fed views as consistent with a stable labour market. Rising layoffs in recent months and a growing number of initial jobless claims, though from low levels, may indicate that the labour market is approaching a turning point. But in the leisure and hospitality sector, the number of jobs is still 900,000 lower than before the pandemic, indicating a potential for continued gains as other sectors shrink. In addition, the labour shortage is apparently making employers hesitant about laying off employees. Our forecast assumes that unemployment will rise during the spring and peak at just below 5 per cent in early 2024. The historical pattern is that an increase in unemployment of more than half a percentage point triggers a vicious circle − forcing many people to curtail their consumption before compensation levels have time to rise. The remaining savings reserves may help to avoid such a situation this time around, but this assessment is uncertain.

Structural challenges to the labour supply.

So far, hopes of boosting supply to improve labour market balance have been dashed. At the end of 2022, labour force participation was still 1 percentage point below its pre-pandemic level. This gap is explained primarily by a decrease in participation by people over age 55. Worries about illness and strong personal finances were probably among the reasons why many people speeded up their withdrawal from the labour market during the pandemic. This should be a temporary problem. Once the individuals who left during the pandemic reach the age when they might have been expected to retire anyway, labour force participation should rebound. However, an ageing population and a more negative US view of labour immigration still suggest that it will be hard to return to a pre-pandemic participation rate. In the absence of a clear uptick in productivity, this means that the Fed is likely to be cautious in its assessment of how fast the US economy can grow over time.

High but decelerating pay increases.

Private sector wage and salary growth slowed a bit during Q3 to just over 5 per cent year-on-year, from nearly 6 per cent in mid-2022. Recent monthly figures also show a slowdown, reinforcing the perception that pay hikes have peaked. But monthly statistics are not fully reliable since they are not adjusted for changes in workforce composition and are often revised. The still tight labour market is an upside risk to our wage and salary forecast.
Inflation seems to have peaked, both overall and excluding food and energy (core inflation). Reduced bottlenecks in the form of shorter delivery times and falling freight and input prices suggest that goods prices will continue to fall this spring, as increased competition forces companies to lower still-high margins. Service inflation is more uncertain. Rents, the single largest component of core inflation (40 per cent), are expected to rise at a rapid pace during the spring. However, since rent increases in new leases appear to have stalled, it will only be a matter of time before rents as measured by the CPI also begin to level off. The Fed is now expressing less concern about rents. The central bank’s focus is on services excluding energy and rents, which, over time, follow changes in labour costs. Such prices were also subdued late last year. But we see a risk of renewed acceleration in early 2023, before the labour market weakens more clearly. Overall, we expect an initially sluggish decline in core inflation. However, both metrics are expected to be back at target by the end of our forecast period. This means that the Fed's favourite metric, core PCE, may be slightly below target again.

The Fed will keep its foot on the brake

Given the mild recession we foresee, the Fed will hold off on declaring victory over inflation. The inflation rate has peaked, reducing the risk that inflation expectations will get stuck at too high a level and helping to prevent a wage-price spiral. But as long as the labour market does not normalise, there will be lingering concerns about wage-driven inflation – especially if rising real incomes drive new consumption. Meanwhile the Fed is aware of the risk of tightening its monetary policy in a slowing economy. Last year the federal funds rate was raised at the fastest pace since the early 1980s. Lower long-term bond yields have provided some relief in financial conditions, partially offsetting the effect of Fed hikes. But banks have continued to tighten lending conditions, which is also reflected in surveys of small businesses. The Fed’s gradual balance sheet reduction is also having an impact. We believe the Fed will hike its key rate one last time during Q1 2023 to a peak of 4.75 per cent. It will begin rate cuts in late 2023, and the federal funds rate will be 3.0 per cent at the end of 2024. It will thus remain above the Fed’s estimated neutral level − around 2.5 per cent – until the end of our forecast period.