Labor Market Resilience Suggests Recession Is Not Imminent

Video Transcript

Economic growth accelerated in the second half of last year, and data released so far in 2023 solidify the case that a U.S. recession is not imminent. Surveys demonstrated some weakness in late 2022 as well, but even there we are now seeing stabilization.

I think that the key to the U.S. economy is the consumer. And data from credit card spending and retail sales for January show a couple of things: Consumers are willing to spend, and they appear to have the runway to do so through a combination of a resilient labor market and relatively healthy balance sheets and credit. These two factors could prove to be a very important source of growth in 2023. In addition, the recent decline in mortgage interest rates could also help mitigate some of the recent weakness in the housing market. It could also support the housing market in the key spring selling season.

There have been some pockets of softness in the U.S. labor market at the end of last year, but overall it remains resilient. There were some high-profile layoffs at large tech companies, but the job market at small and medium-sized firms, especially in industries like hospitality and leisure, is still very tight.

Wage growth has eased from last year’s peak, which is a welcome relief for the Fed. However, it is not yet consistent with the central bank achieving its 2% inflation target. For this reason, policymakers will be sensitive to any reacceleration in job growth because this could stall the recent progress that we’ve seen on inflation.

Consumer price inflation appears to have peaked. Here I look at the three broad categories of inflation that the Fed likes to focus on—core goods, rents, and services excluding rents. There are reasons to be cautiously optimistic here. 

But this progress has been somewhat uneven across the major components, and for the Fed, I think they are looking for broadly based improvement in order to feel comfortable that inflation will be on a sustained downward trend.

Our view is that goods inflation is likely to decline further as a result of ongoing supply chain improvement and also lower consumer demand for goods. In the rent category, things could be a bit sticky for longer. Private sector estimates of rent are falling, but these have a lagged effect and will likely feed into lower inflation only in the second half of the year.

So that leaves services ex. shelter as the one broad category of inflation where prices could stay high for longer. We only see services inflation softening once the labor market weakens, and this is likely towards the end of the year.

All these factors make the Fed’s policy tightening even more data-dependent. As a result, we expect less forward guidance from the central bank compared with last year, when it became evident that the Fed was behind the curve and it needed to raise interest rates expeditiously.

The Fed is now increasing interest rates at a much slower pace, a quarter percentage point per meeting. And monetary policy is firmly in restrictive territory. Over the coming months, we expect the Fed to continue increasing interest rates at this slower pace and for the terminal rate to be above 5%. However, the focus for the Fed will be to hold a restrictive policy for as long as is needed to lower inflation.