Recession still likely, but odds of soft landing rising

Wells Fargo Research Team Wells Fargo

The U.S. economy looks to be downshifting. While real GDP growth expanded solidly to close 2022, the quarter ended with considerably less momentum than when it began, with monthly economic data pointing to a clear weakening in growth as the year wound down. We expect this loss of momentum to carry over to Q1 and look for a -0.6% annualized drop in real GDP during the quarter.

At present, real GDP growth looks set to bounce back in Q2-2023 as the Q1 drag stemming from less inventory building reverses. That said, a recession beginning in the second half of the year remains our base case forecast as the lagged effects of inflation and tighter monetary policy result in a pullback in consumer spending, business and residential investment.

Although a mild recession in the second half of the year remains the most likely outcome, there have been several positive developments recently that, in our view, boost the odds that the economy can avoid a recession.

The likelihood of a soft landing is rising for several reasons. January's remarkably strong jobs report is evidence that labor market remains robust at present. We have upgraded our labor market forecast and now expect smaller declines in employment this year and next. We also now look for the unemployment rate to crest at a quarterly average of 4.8% in Q1-2024, a lower peak than previously forecast.

Inflation appears to be receding at a pace that is a bit faster than we had previously anticipated. The annualized run rate of CPI inflation over the previous three months averaged just 1.8%. In addition, there are tentative signs that wage growth, which is an underlying driver of prices in the labor-intensive service sector, is beginning to moderate.

The recent cooling in wage pressures without a material downgrade in labor market conditions is an encouraging sign that tighter monetary policy is skimming the froth from the punch bowl without removing it entirely.

Another reason for cautious optimism is that the combination of easing inflation and solid income growth appears to be enhancing consumer purchasing power. Real disposable income growth has been flat or positive in every month since July. Diminished price pressures and relatively stronger employment growth lessen the risk consumer spending halts completely as we currently anticipate.

The FOMC hiking the federal funds target to a terminal range of 5.00%-5.25% remains our base case. With economic growth downshifting and inflation cooling, however, we now believe the Committee will put even more weight on incoming economic data in order to calibrate monetary policy.

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Wells Fargo Research Team

Wells Fargo

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