Climbing down from peak inflation looks increasingly challenging

We continue to expect the economy to maintain a positive trajectory over the next two years. That noted, the absence of fiscal and monetary stimulus means growth is set to moderate significantly, a slowdown amplified by inflation pressures. We now expect real GDP growth to amount to 2.4% for 2022 as a whole, a slightly slower pace than our previous forecast update last month. Furthermore, we expect growth to cool to 2.0% in 2023. In the second half of 2023, we expect growth to shift lower to just above 1% on a sequential basis.

Our view that the labor market is on track for further tightening remains intact. We anticipate the unemployment rate to fall to 3.3% in Q4-2022. A slower pace of job growth and increased labor force participation is likely to lead to the unemployment rate to rise slightly in the back half of 2023. We expect the unemployment rate to average 3.4% in Q4-2023.

One notable change with our May forecast update is a slightly stronger pace of inflation throughout the forecast horizon. We expect the year-over-year rate of core PCE inflation to soften slightly over the course of the year but still be up a hot 4.4% in Q4-2022. Inflation is likely to cool from there, however, the core PCE deflator is still on track to average 2.8% in Q4-2023.

Another significant change to our forecast is that, in order to tamp down inflation, we now believe the Fed will raise the effective federal funds rate at a slightly more aggressive pace this year. We now look for a 50 bps hike at the June, July and September FOMC meetings. Furthermore, we expect five more 25 bps rate hikes over the course of the next two years, with the fed funds rate peaking at a 3.50%-3.75% range in Q2-2023.

Personal consumption was stronger than anticipated in Q1, which has encouraged us to slightly boost our real PCE forecast for the year. That noted, we expect growth in consumer spending to slow, with growth in real PCE not exceeding 2% at any point in the forecast period.

While we have not made meaningful changes to our forecast for business fixed investment, the outlook for capital spending remains a bright spot. We look for business investment to expand 6.0% in 2022 and 4.3% in 2023.

The recent pullback in existing home sales has led us to reduce our residential investment forecast to a 3.0% decline in Q2-2022. Some slowing now seems inevitable, but buyer demand is likely to remain resilient thanks to an incoming wave of young Millennial buyers. Overall, the housing market losing steam as interest rates climb higher may be offering a preview of what is to come with the rest of the economy.

Climbing down from peak inflation looks increasingly challenging

The U.S. economy started off the year on the wrong foot. Real GDP declined 1.4% on a quarterly basis in Q1-2022, the first quarterly decline since the pandemic-induced plunge registered in Q2-2020. Perhaps not surprisingly, the step back in economic growth to start the year has stoked fears that the economy is slipping into a recession. However, as we noted at the time, the contraction is, in part, payback for the robust 6.9% rate of growth experienced in final quarter of 2021. On top of a relatively smaller inventory build, imports surged well ahead of the pace of exports during the first quarter, widening the trade deficit substantially. Together, inventories and net exports subtracted 4.0 percentage points off of the top-line real GDP growth during the quarter. Separating the wheat from the chaff, the core parts of GDP, which better reflect underlying economic activity, all advanced solidly, with growth in consumer spending, business investment and residential investment all rising during the quarter.

Continued growth in these core segments of the economy is a timely reminder that households and businesses remain in strong financial shape thanks in large part to accommodative fiscal and monetary policy for much of the past two years. The underlying strength of household and business balance sheets is one of the reasons why we continue to expect the economy to maintain a positive trajectory over the next two years. While we have not made meaningful changes to our forecast for business fixed investment, the outlook for capital spending remains a bright spot. Personal consumption was stronger than anticipated in Q1, which has encouraged us to slightly boost our real PCE forecast for the year. That noted, we expect growth in consumer spending to slow, with growth in real PCE not exceeding 2% at any point in the forecast period. Overall, the absence of fiscal and monetary stimulus means economic growth is set to moderate significantly, a slowdown amplified by inflation pressures. We now expect real GDP growth to amount to 2.4% for 2022 as a whole, a slightly slower pace than our previous forecast update last month. Furthermore, we expect growth to cool to 2.0% in 2023.

Inflation remaining persistently high is another factor that is contributing to the slowdown. One notable change with our May forecast update is a slightly stronger pace of inflation throughout the forecast horizon. While we remain of the belief that inflation has likely peaked and price pressures should abate somewhat over the remainder of the year, the climb down remains challenging. Despite some recent softening, the sharp run-up in home prices and apartment rents has yet to be fully reflected in the major inflation indices, meaning higher shelter costs is likely to offset some of the expected cooling in goods prices in the months ahead. COVID-related lockdowns in China, which is a key node in the global supply chain and one of the world's largest manufacturing hubs, presents some new uncertainty regarding the pace at which goods prices will decelerate. What’s more, with no resolution to the war in Ukraine in the foreseeable future, energy and food prices stand to remain elevated with increased risk of moving higher.

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