The Big Idea
Out-of-consensus calls on the economy in 2024
Stephen Stanley | November 17, 2023
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.
Heading into each of the last two years, it was easy to lay out areas where my view of the economy differed from consensus. I was far more optimistic on growth, mainly reflecting an upbeat view of the consumer, and far more hawkish on the Fed. And that optimism was largely borne out. But as we look ahead to 2024, the tailwinds left over from pandemic are fading and the Fed’s rate hikes will continue to put a drag on the economy. That leaves me looking for a substantial slowdown—call it a soft landing—putting me pretty close to the consensus for growth, unemployment and inflation. But I still see important differences between my outlook for 2024 and the consensus on the timing of slowdown, the timing of cuts and the timing of QT.
First half, second half economic growth
While my real GDP growth projection of 1.1% for the four quarters of 2024 is only a few tenths above the consensus, the profile of growth is at odds with the prevailing view. The consensus calls for the economy to slow drastically, beginning right about now. The latest Blue Chip Economic Indicators survey, conducted in early November, has real GDP growth decelerating all the way from 5% in the third quarter to a measly 0.9% in the current quarter, then slowing further to a low point of 0.4% in each of the first two quarters of next year. In the second half of the year, the consensus envisions a sizable pickup in economic activity, accelerating to a 0.9% annualized increase in the third quarter and to a 1.5% rise in the fourth.
In contrast, I believe that the economy, while slowing, retains some momentum in the short term. I look for a roughly 2% annualized advance in the current quarter, followed by gains in the neighborhood of 1% in the first and second quarter of next year. In my forecast, the third quarter will be the weakest of the year, the point at which the accumulated drag from restrictive Fed policy and high interest rates more generally peaks. The significant pickup in growth that the consensus projects for the second half of 2024 is more likely to come in 2025, by which time, the Fed should be cutting rates in earnest and interest rates more broadly should be coming down.
No Fed easing in the first half
In recent days, financial market participants have been moving up the timing of the first rate cut noticeably. As of the end of November 15, the July 2024 fed funds futures contract was trading at 5.02%, about 30 bp below the current level of the funds rate. Since the July 2024 FOMC meeting takes place on July 31, the July futures contract, which is a bet on the average level of the funds rate over the course of the month, reflects expectations of where the rate will be after the June 2024 FOMC meeting, setting aside the remote possibility of an intermeeting policy move.
In my view, the timeframe that financial market participants are assuming for Fed rate cutting to commence is far premature. Chair Powell and most Fed officials have forcefully argued that the fight to bring inflation under control is far from complete.
I believe that the FOMC will remain on hold for most of 2024, possibly beginning to cut rates in the fourth quarter. In fact, I would go a step further. Though it is not my base case, if the Fed does make any changes to the policy rate in the first half of the year, it would most likely be renewed hiking. The most plausible risk to my forecast is that core inflation stays elevated, forcing the Fed to resume its rate hiking.
QT rolls on
For at least a year, some analysts have been arguing that the Fed was going to need to stop reducing its balance sheet soon. However, every time that a Fed official has addressed the topic of the balance sheet, including Chair Powell several times at post-FOMC press conferences, they have said that QT is likely to continue for the foreseeable future.
At the end of 2019, the Fed’s balance sheet totaled $4.1 trillion, while the level of bank reserves was $1.6 trillion. At its peak, the Fed’s balance sheet totaled $8.9 trillion, while bank reserves were around $3.8 trillion. By early November, the balance sheet had only shrunk to $7.8 trillion, and bank reserves were $3.36 trillion.
In contrast, if we assume that the size of the balance sheet was appropriate at the end of 2019 and scale up those numbers by the 28% increase in nominal GDP over the past four years, that would take the proper size of the balance sheet as of the end of this year to around $5.25 trillion, roughly $2.5 trillion below the current size. That very rough estimate may not be exactly the “right” number, but it is difficult to see why the Fed would end QT for a long time—the current pace of roll off works out to a little less than $1 trillion a year—if it is serious about normalizing the amount of liquidity in the economy.
Still, market participants continue to believe that the Fed will end QT relatively soon. In the most recent quarterly survey of primary dealers conducted by Treasury in advance of the November refunding announcement, the median estimate had QT ending in the summer of 2024.
Perhaps many analysts believe that the Fed would not cut rates and reduce the balance sheet at the same time. However, Chair Powell was asked about this earlier this year, and he specifically stated that the Fed could do both. If rate cuts are coming in the context of a soft landing and receding inflation, I would expect QT to be sustained without much debate even after rate cuts begin. My projection is that QT will continue at the current pace throughout 2024 and probably for most, if not all, of 2025.
Of course, if the economy sinks into a recession and the FOMC finds itself needing to support activity as quickly as possible, then QT will be halted regardless of whether the balance sheet is anywhere near the right size. However, that is not the scenario envisioned by either the consensus or me for 2024.