The Big Idea
A midterm exam on the economy
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. This material does not constitute research.
Much can happen over the balance of the year, but my main economic calls for 2023 are holding up well. So far, so good. I expected the economy to outperform expectations, avoiding a recession, the labor market to remain solid, inflation to recede more slowly than generally projected, and the Fed to hike rates above 5% and leave them there well into 2024. Some of the details of the forecast have changed since late last year, but the broad narrative continues to anticipate the economy well.
Recession deferred
My first economic call for 2023 was that the economy would continue to grow, avoiding a recession until at least 2024. At the turn of the year, this was a sharply out-of-consensus call. The January Blue Chip Economic survey had median real GDP readings for the first quarter of -0.5% and for the second quarter of -0.9%. And 65% of the respondents expected a recession to begin in 2023.
My basis for optimism stemmed mainly from the fact that households were sitting on a massive cushion of excess liquidity accumulated since early in the pandemic. That theme has served me well. Real consumer spending posted a 4.2% annualized gain in the first quarter, rebounding from a sub-par fourth quarter, and is on pace to post a gain of around 1% annualized in the second quarter of this year. Such a result would yield about a 2.5% annualized advance for real consumer spending in the first half of the year, even better than 2022’s 1.7% rise.
As a result, real GDP expanded at a 2% annualized clip in the first quarter and perhaps by around 1% in the second. While this is certainly not robust growth, it is comfortably clear of recessionary territory and far above the consensus forecast from six months ago.
While many economists believe that households have burned through their excess liquidity, the Federal Reserve’s household balance sheet data indicates otherwise. In a recent piece, I ran through the calculations suggesting that, even after adjusting for inflation, households have an extra $1 trillion or so in liquid assets. I look for this cushion, along with solid income growth, to keep consumer spending, and in turn the overall economy, on a similar modestly positive track in the second half of the year—between 1% and 2% growth. In contrast, the most recent Blue Chip survey calls for roughly flat real GDP in the second half of the year.
Labor market holds up better than expected
Consistent with the consensus recession call, economists were looking for a quick collapse of the job market heading into 2023. The monthly Bloomberg survey of economists conducted in mid-January had payrolls averaging growth of only 100,000 in the first quarter and then moving into negative territory for the rest of the year, so that the economy was projected to lose jobs on balance in 2023. The unemployment rate was projected in both the Blue Chip and Bloomberg surveys to average 4.8% in the fourth quarter of 2023, a rise of over a full percentage point.
In contrast, my view entering the year was that there were significant parts of the economy that were still dealing with labor shortages and had pent-up demand for workers. I consequently called for only a gradual moderation in labor demand over the course of this year. I called for the unemployment rate to remain largely steady in the neighborhood of 3.5% for most or all of 2023.
As it turns out, job growth has begun to moderate in the first half of 2023, but it has remained robust, averaging 278,000 a month. The JOLTS job openings data offer a clear view of the labor market situation. Job openings have fallen by over 2 million from the early-2022 low to just under 10 million, signaling significant cooling. However, the latest reading remains historically robust. The all-time peak prior to the pandemic was 7.5 million. Meanwhile, the unemployment rate has been largely steady in the first half of the year, averaging 3.5% with the latest reading for June at 3.6%.
Looking ahead, I expect the pace of job gains to continue to moderate but only gradually, remaining well ahead of the pace needed to keep up with trend population growth—about 100,000 per month—for a while longer. I project the unemployment rate to remain within a tenth or two of the 3.5% mark for the balance of the year.
Inflation moderates only gradually in 2023
At the turn of the year, the consensus call for inflation, both headline and core, was for a steady deceleration, taking year-over-year advances for both below 3% by late 2023.
As with growth and employment, I projected that inflation would cool in 2023 but at a much slower pace than the consensus. I felt that shelter costs would continue to rise sharply in the first half of the year and that inflation in a number of service categories had become entrenched and would prove stubbornly high.
Notwithstanding the downside surprise in the June CPI, core inflation has been far higher than the consensus projected in the first half of the year. The core CPI ran at a 4.8% annualized rate in the first two quarters of the year, while the core PCE deflator may have risen at about a 4.5% pace.
It does appear that underlying inflation is finally beginning to moderate, but I still look for core inflation to run at close to a 4% pace over the four quarters of 2023 –4.1% for core CPI and 3.8% for core PCE. Underlying measures, such as median and trimmed-mean gauges are running well above the traditional headline and core measures, suggesting that inflation pressures remain broad-based, which likely points to a long and difficult path back to the Fed’s 2% target.
No easing in 2023
By the end of 2022, the FOMC had raised the fed funds rate target to a range of 4.25% to 4.50%. The consensus economic view called for 50 bp more tightening in the first quarter, according to the January Bloomberg survey. Fed funds futures contracts at the time had the Fed getting close to 5% by mid-year but then easing in the second half of 2023 with a year-end funds rate projection just above 4.5%.
Consistent with my economic and inflation estimates, I entered the year believing that the Fed would hike rates above 5% in the first half of 2023 and then leave them there until the summer of 2024.
Over the past six months, I have been forced to adjust my Fed call, but in the opposite direction from the prior consensus. I now expect the Fed to keep hiking into the fall, eventually reaching 5 5/8% by early November, a quarter point above the current consensus. I still believe that the first rate cut will not come until the summer of next year. In contrast, fed funds futures and SOFR futures contracts currently have the policy rate broadly steady in the second half of this year and then falling by almost 100 bp by mid-2024.
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