Economic Outlook 2023: Is a recession on the horizon?
Q&A with new Nationwide Chief Economist Kathy Bostjancic
A bear market, war in Ukraine and supply chain imbalances are just some of the unforeseen developments that impacted the U.S. and global economies in 2022. But what to expect in 2023?
As the new year approaches, Nationwide Chief Economist Kathy Bostjancic and her team of economists are keeping a close watch on global events and key economic indicators to discern how the economy is likely to develop. In October, Bostjancic succeeded recently retired, former chief economist David Berson. She is the second person and the first woman to be named chief economist at Nationwide. Frequently quoted by national and global business media, she joins Nationwide with both domestic and international economics expertise.
Bostjancic recently discussed the economic outlook for the next six-to-12 months, expectations for the Federal Reserve Open Market Committee, and the likelihood that the U.S. will be in a recession this time next year.
Q: How would you assess where the economy is today?
Bostjancic: The economy is still running at a sturdy pace as the labor market remains strong and consumers dip into pandemic-related savings to fund their spending. However, the economy looks to be in the late part of the business cycle where economic activity is buoyant and resources in the labor and product markets are strained, which leads to heightened inflation pressures. The labor market remains very tight as characterized by a very low unemployment rate, 3.7% in October, and the high number of job openings per unemployed persons, roughly two-to-one. While strong labor demand underpins rapid wage increases, wage gains still lag the rate of inflation, leading consumers to dip into their savings and rely more on credit to fund their current consumption.
Q: Why has inflation become such a problem?
The persistently high inflation is a consequence of pandemic-related factors that include disrupted supply chains, record amount of fiscal stimulus and extremely easy monetary policy that fueled consumer and business spending. This resulted in aggregate demand far outstripping aggregate supply, pushing the economy further into a late-cycle phase. The outbreak of war in the Ukraine exacerbated supply constraints, especially for food and energy, leading to another leg up in inflation.
Thankfully, an easing in supply chain stresses and a shift away from heavy goods spending towards more services has led to a marked slowing in consumer goods inflation. Commodities less food and energy inflation decelerated to 5.1% in October from the recent peak of 12.3% in February. However, core services inflation, which excludes energy services, has accelerated to a 40-year high of 6.7%. The sharp disinflation in goods prices has allowed the headline consumer price index (CPI) year-over-year rate to cool from the recent peak of 9.1% to 7.7%, while core CPI has decelerated more gradually to 6.3% from the cycle-high 6.6% in September. Going forward, we look for the disinflation in the goods sector to continue, but the more gradual easing in services inflation should keep overall inflation’s improvement gradual.
Q: The Federal Reserve Open Market Committee, led by its Chairman Jerome Powell, has been moving aggressively to raise interest rates to tamp down inflation. Do you expect more rate hikes in the next six months?
The Federal Reserve is resolutely focused on reducing the pace of inflation back towards its 2% target level in the medium-term. As such, policy officials are poised to drive the policy rate to 5.0-5.25% and hold it at that restrictive level through 2023. Additionally, the Fed is shrinking its balance sheet at a target cap of $95 billion per month.
Aggressive Fed tightening has hit the housing market most noticeably since it is the most interest-rate sensitive sector in the economy. With mortgage rates soaring to 7%, the housing market is already in a recession and the sector is a leading indicator for the broader economy.
Beyond housing, higher corporate borrowing rates have soured investors’ sentiment towards technology stocks since they are the most debt-intensive sectors. Consumer borrowing rates for autos and credit cards have also increased, but the large pent-up demand for autos amid still constrained supply supports auto sales. For now, consumers continue to rely on pandemic-related savings to help fund their spending, but as employment demand cools, we expect consumers will be less willing and able to dip into savings by mid-2023.
Q: Are we headed for a recession? And if so, how severe might it be?
Looking ahead, we foresee a confluence of factors pushing the economy into a moderate recession starting in mid-2023. Elevated inflation, rising interest rates, and the diminished level of excess savings will slow consumer spending. Corporate earnings growth will decline as profit margins compress further and top-line revenue growth slows as consumer spending cools. Corporations will then be forced to curtail hiring and pull back on capital expenditures. The eventual job losses will lead to a contraction in consumer spending, leading the economy into a recession in the second half of 2023.
We think it will be a more moderate-sized recession, with a peak-to-trough decline of around 1.6%, versus the average post-WWII average of 2% - excluding the Great Financial Crisis and the latest covid-induced recession.
Buffering the economy from a deeper recession are continued excess pandemic-driven savings, pent-up demand for consumer services and autos, healthy overall consumer and business balance sheets, and the likelihood that inflation cools next year, albeit remaining too hot for the Fed.