US 2023 Key Themes – Will the landing be hard or soft?

The US economy will need a lot of luck to avoid a recession next year because the headwinds are about to intensify. We have identified several key themes that will shape the economy in 2023.

US 2023 Key Themes:

• How hard will the Fed keep pushing on the brakes? The central bank now anticipates hiking the target range for the fed funds rate more than either we or financial markets anticipate. Historically, in bouts of high inflation and a weakening economy, the Fed has been slow to ease monetary policy. Therefore, we don’t anticipate the Fed cutting interest rates in 2023.
• How will the inflation outlook unfold? This is key to the outlook for monetary policy, financial market conditions, and the broader economy. Goods disinflation is underway, but services will remain strong for some time. Relief on services inflation will come when the housing components of the consumer price index roll-over and nominal wage growth moderates. The Fed also wants evidence that services inflation excluding housing is also cooling. The recent easing in supply-chain stress is encouraging for the inflation outlook, but supply-side conditions will pose a drag on the economy in 2023.
• The key to the outlook for job and wage growth is the size of the gap between labor demand and labor supply. The Fed needs to rebalance the labor market to help put downward pressure on nominal wage growth. Labor demand is easing but supply needs to increase further.
• Concerns about financial stability are growing. These are not misplaced as Treasury liquidity is under pressure, leveraged loans could be problematic, and there may be unknown potential gremlins in the shadow banking system.
• Corporate profit margins are another key. If they hold-up, then some of the financial stability concerns should fade. So far, businesses have been successful in passing on higher input costs to the consumer, but this will be tested as the economy begins to weaken.
• House prices will decline moderately next year because inventories will remain low. Many homeowners are rate-locked, which will create a strong disincentive to list their home for sale. Also, the amount of distressed inventory that hits the market will be limited.