US growth momentum is slowing following the surprising resilience in 2023. We expect real GDP growth to average close to zero for 2024, with a below-trend average of 1.3% in H1 ahead of a mild recession in H2.
Slowdown, recession and last mile inflation risk
After surprising strength in 2023, growth momentum appears to be cooling. Financial conditions have eased recently, but remain restrictive, which will likely exert downward pressures on the economy with a lag. Households and businesses have been well-insulated from rising interest costs so far, but higher borrowing costs will increasingly weigh on cyclical spending.
We expect business financial stress to intensify throughout the year, with default rates continuing to rise. Slowing growth and inflation will also likely lead to a deceleration in revenues, with a strong dollar adding additional headwinds to multinational corporations and export-driven businesses.
In addition to looming headwinds, some one-off positive shocks for capex are likely to fade. Industrial policy from CHIPS and the Inflation Reduction Act (IRA) led to a surge of investment in the tech sector in 2023. We do not expect a sharp reversal, but the fastest pace of increase has likely passed.
Labor markets have slowed significantly, even without a sharp growth downturn or widespread layoffs. The monthly run-rate for nonfarm payrolls has decelerated to below 200k — in line with its pre-pandemic average — and the unemployment rate has drifted higher to 3.7%.
So far, this slowdown appears to be a normalization after frenzied hiring and labor hoarding in 2021-22. Measures of hiring and labor demand have moderated, and the pace of layoffs has increased modestly.
Taken together, slower hiring and a faster run-rate for layoffs suggest a further increase in the unemployment rate. We expect the unemployment rate to move above 4% in H1 2024, with a sharper increase only occurring later after the onset of recession
Solid labor income growth will likely support consumer spending. Tighter financial conditions are a strain for households, but this is more likely to lead to a slowdown than an outright downturn in the near term.
Household balance sheets have been well insulated from higher rates and tighter financial conditions. Around 70% of household debt is mortgage borrowing, which is overwhelmingly fixed-rate debt still paying low rates. Despite home price appreciation and rising homeownership rates, mortgage debt payments are still below 2019 levels as a percentage of disposable personal income.
Despite this solid foundation, headwinds are building for household finances. Most household liabilities are insensitive to rising rates, but credit card interest costs are increasing, and delinquency rates have picked up. The resumption of student loan payments (following years of forbearance) is also a drag on household cashflows.
Consumer surveys demonstrate that higher borrowing costs and tighter lending conditions are weighing on demand for vehicles and other large durable goods. The University of Michigan consumer sentiment survey showed a sharp rise in the share of households that claim it is a bad time to make large purchases due to high interest rates. Rejection rates for consumer credit applications have also increased, and a rising share of households indicated that they have been discouraged from even applying for credit.
We believe disinflation will likely continue in 2024 and forecast core PCE inflation to decelerate to 2.2% in Q4 2024 from 3.2% as of November 2023. Disinflationary forces appear to be concentrated in vehicle prices and rent, while we expect inflation of supercore components to moderate more gradually.
Higher interest rates started to drive down vehicle prices, which make core goods prices one of the primary sources of disinflation. Leading indicators point towards continuing deceleration in rent inflation through 2024. Expected moderation in vehicle prices and rent inflation will likely have a larger disinflationary impact on core CPI than core PCE inflation.
The remaining part of core inflation is non-rent core service prices, so-called supercore inflation. CBO and CMS forecasts for cost increases for Medicare services point to stable inflation for healthcare service prices. However, about one-third of supercore components such as food service prices seems to be sensitive to wages. Based on our analysis, wage growth tends to be sticky and thus those wage-sensitive prices will likely moderate more gradually than rent and core goods prices. We expect supercore PCE inflation to fall to 3.1% y-o-y in Q4 2024, from 3.5% in November 2023.
Realized inflation is falling, but there will be lingering risks of a reacceleration. We think wage growth and hence supercore inflation provide an important guide for assessing these risks. Many policymakers (including Chair Powell) have argued that any evidence that tightness in the labor market is no longer easing could put further progress on inflation at risk, which underlines the importance of labor markets and wage growth for the inflation outlook (Fig. 13).
One lesson from the 1970s inflation was not to declare victory prematurely without broad corroboration that both inflation and wage growth have slowed (Fig. 14). In the 1970s, a series of shocks (including the two oil crises and depreciation of the US dollar associated with the end of the Bretton Woods exchange rate regime) exerted inflationary forces. The Fed tightened policy to prevent a positive output gap, but did not remain restrictive enough to address building demand pressures in wage growth and persistent services inflation. Prices reaccelerated and expectations became unanchored, leading to a prolonged period of high and volatile inflation.
Disinflation and sluggish growth are likely to discourage the Fed from hiking rates further, and we expect a tentative start to rate cuts in June 2024. However, we believe the Fed would not be comfortable easing aggressively until inflation and wages decelerate more decisively.
In our view, it will be difficult for the Fed to ease quickly as long as growth is solid and realized inflation remains above target. We see two key uncertainties that should discourage aggressive rate cuts until a recession is underway.
First, as the prior sections suggest, inflation risks will likely remain skewed to the upside even when realized core PCE is printing close to the Fed’s target. It is always difficult to distinguish between temporary, volatile drivers of inflation and structural trends. Our inflation forecast for 2024 suggests disinflation will be driven mostly by noisy goods prices and backward-looking rents, raising the risk that ‘underlying’ inflation is still elevated.
Second, rate cuts would raise the risk that policy becomes accommodative. Rates are well above the Fed’s model-based estimates of ‘neutral,’ but these models are unreliable in real time. Small differences in assumptions lead to significant differences in estimates across models.
In the past, rate cuts outside recessions have been limited, and were often preceded by financial stress. Since rate decisions were made public in 1994, there have only been three instances of non-recessionary rate cuts, in 1995, 1998, and 2019 — following the Mexican peso crisis, LTCM, and QT-related money market stress. In each case, there was only 75bp of cumulative easing. Without salient financial stability risks, the pace and magnitude of pre-emptive rate cuts will likely be limited.
Tighter financial conditions have not led to acute stress yet, but in our view, the risk of a downturn remains elevated.
The Fed’s aggressive rate hikes and slowing inflation are raising real interest rates. In addition, the economy is slowing, weighing on revenue growth of US businesses. Refinancing maturing corporate debt in 2024 and subsequent years will also increase the debt burden on businesses gradually. The banking sector is still facing pressures as interest margins for small banks have continued to be squeezed. Against this backdrop, credit conditions for the business sector continue to tighten, which corroborates recent increases in the speculative corporate bond default rate.
Based on our calculation, the interest coverage ratio, a measure of the ability of businesses to pay interest, started to deteriorate this year. Historically, changes in the interest coverage ratio tend to affect certain types of business investment with a one-year lag. Overall, we will likely see a more substantial impact from credit tightening on business investment in coming quarters, causing a capex-driven recession in H2 2024.
Once a recession is underway, the Fed’s employment and inflation mandate are both likely to suggest policy can ease.
Even in a mild recession, unemployment is likely to rise significantly. We expect the headline unemployment rate to rise towards 5% by the end of 2024, and increase to a peak in the mid-5% range by 2025. Wage growth tends to be sticky early on in recessions, but it predictably declines after a sufficient lag.
We expect a recession in H2 2024 would likely push down supercore PCE inflation to its pre-COVID level in 2025. Additional disinflationary forces stemming from a recession should make the Fed confident that the risk of inflation rebounding has diminished, enabling it to launch a large scale rate cutting cycle in September 2024, along with an end to quantitative tightening.
With divided government and a national election looming in November, we do not expect any significant fiscal easing in response to a recession. 2024 is an election year and the administration cares about slowing growth. However, House Republicans likely have less incentive to support policy that boosts the economy. Inflation risks and concerns of elevated deficits might dampen support for stimulus, even among Democrats.
Risk scenarios to our economic outlook
The drag from tight financial conditions makes a recession seem more likely than not, however a soft landing remains a risk.
Cyclical spending has already fallen significantly since the start of the tightening cycle, and it is possible that demand stabilizes even if financial conditions remain restrictive. In addition, strong balance sheets of households might provide more support to the broader economy than we currently assume.
Since late 2021, the Fed has been prioritizing the inflation leg of its dual mandate. Officials have repeatedly said that returning inflation to 2% was their priority, and that they would do whatever was necessary to achieve this objective.
Since October, there have been signs of wavering. Chair Powell admitted that the FOMC started to discuss rate cuts in 2024 at the December meeting, and he did not push back against aggressive market prices of five to six 25bp rate cuts at his post-FOMC press conference.
Overall, Our forecast for Fed policy in 2024 assumes the emphasis on inflation will persist, but the risk of a more aggressive dovish pivot has increased. Importantly, due to policy lags, disinflation and sluggish growth will likely persist for at least a few months regardless of the Fed’s policy approach even if easing financial conditions exert renewed inflationary pressures with a lag. In our view, this would risk an inflation reacceleration in the medium term, but there is no near-term circuit breaker that would prevent the Fed from easing policy or lead to a rapid hawkish reversal.
Our expectation is that a 2024 recession would be mild, with just two quarters of negative growth and the unemployment rate peaking around 5.3%. In our view, this is a reasonable base case given the fundamental strength of household balance sheets and the lack of overinvestment during the expansion. That said, recent history shows that recessions often trigger financial stress, leading to a negative feedback loop and a more severe downturn.
We do not see a clear catalyst for financial stress, but growth downturns can reveal hidden vulnerabilities or ‘break’ otherwise healthy markets. The past three recessions have coincided with equity sell-offs of 30% or more, and even past mild recessions typically lead to some credit stress.
Read the full report here: 2024 Global Macro Outlook (nomuranow.com).
Senior US Economist
Senior US Economist
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