The Big Idea

Out-of-consensus calls on the 2023 economy

Stephen Stanley | November 18, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Consensus calls for a slight recession in the first half of 2023, a rapid cooling of inflation, and modest Fed easing by late in the year. But the consumer looks likely to prove resilient, allowing the economy to continue expanding and the labor market to remain tight for a while longer. Inflation may also prove harder to conquer than consensus anticipates. So once the FOMC ends the current tightening cycle, likely in the first half of 2023, my call is that it will remain on hold for at least a year.

All of this leads to four calls outside the consensus on the 2023 economy:

• Recession deferred
• The labor market holds up better than expected
• Inflation moderates only gradually in 2023, and
• No Fed easing in 2023

Recession deferred

One prominent consensus call for 2023 is that the economy will contract in real terms in the first half of next year, a mild recession. The latest Blue Chip Economic Indicators survey has a median of -0.6% for the first quarter and -0.3% for the second. I agree that the Fed will ultimately have to raise rates enough that the economy is more likely than not to endure a mild recession.  However, I see this coming much later, perhaps in late 2023 but most likely in 2024.  A recession is by no means a certainty. But I would consider it likely – just not in the near term.

The main reason for my optimism is that households continue to have a multi-trillion cushion of excess savings accumulated during the pandemic. They began to dip into that cache in the spring and summer of 2022 but have not even come close to exhausting this backstop.  As a result, consumer spending in real terms should continue to post modest advances for much of next year even as inflation continues to strain budgets.

Labor market holds up better than expected

In a related call, the consensus looks for the labor market to cool substantially in 2023.  In fact, the latest median forecast has the unemployment rate surging to an average of 4.7% by the fourth quarter of next year, well above the Fed’s view of a 4% rate consistent with full employment.  However, labor demand has proven surprisingly persistent this year, and I suspect that job openings and hiring will remain elevated for a while longer.

We are already seeing layoffs in a handful of specific industries, like tech, mortgage lending and warehouses. But payroll gains have remained quite broad and substantial. Industries that suffered painful labor shortages during the pandemic are still trying to catch up to desired staffing levels, with most of the major categories in the service sector still posting large monthly job advances.  Moreover, I suspect that even if firms see demand flag next year, many employers will be slow to let good workers go, having had to work so hard and for so long to acquire them.

Employment increases look likely to slow throughout the year but to remain solidly in positive territory.  In fact, I project the unemployment rate will run in the neighborhood of 3.5% for most and perhaps all of 2023 before finally rising in earnest in 2024.

Inflation moderates only gradually in 2023

The current consensus calls for a rapid, almost miraculous cooling in inflation next year. The latest Blue Chip median forecast calls for the CPI and the PCE deflator to slow to around a 3% annualized clip by the second quarter of next year—not a year-over-year reading, but an annualized quarterly increase.  That equates to roughly 0.25% per month, a far cry from recent inflation results. By the second half of the year, the consensus sees inflation, both headline and core, running at about a 2.5% pace, just a modest amount faster than the Fed’s 2% target.

This seems excessively optimistic to me. Core inflation has broadened and appears to have become more entrenched, as many of the most persistent categories have accelerated in recent months.  In particular, shelter costs have been gathering upward momentum.  Historical data show that the shelter costs component of the CPI tends to lag measures of rent and home prices by about a year, which suggests that the largest component of the core will continue to accelerate until at least next spring before even beginning to moderate.  Similarly, inflation in a number of services categories tend to follow labor costs with a lag of several quarters, and there has yet to be a decisive moderation in wage gains.

As a result, I look for inflation to slow but not as quickly as the consensus.  I have the PCE headline and core indices running in the neighborhood of 4% year-over-year by the end of 2023, which appears to be about a full percentage point higher than the consensus.

No Fed easing in 2023

Despite repeated pushback from a number of Fed officials, market participants continue to price in modest rate cuts toward the end of 2023, suggesting a relatively quick turnaround after hikes conclude in the first half of the year.

Largely in conjunction with my inflation outlook, I believe that the Fed is not going to be in a position to cut rates any time soon.

In my view, the Fed will not be inclined to consider rate cuts until inflation moves down to within reach of the 2% target, with a clear path to that level.  Perhaps the Fed would consider easing once inflation moves down to around 2.5%, as long as it is on a downward trajectory.  The state of the economy and the labor market will also factor into the FOMC’s thinking, but inflation is likely to be the predominant determinant.  In any case, I look for the current hiking cycle to end in May at 5.125%, and I currently have the Fed on hold for five quarters, until the summer of 2024.