A recession is now most likely economic outcome in 2023
Although the U.S. economy continues to expand toward the end of 2022, with a very strong labor market, the outlook for next year has softened.
Inflation appears to have peaked but remains much too high for the Federal Reserve, and the central bank has been aggressively raising interest rates to slow economic growth and bring down inflation. Higher interest rates are already weighing on the housing market, and are starting to weigh on other parts of the economy.
With the Fed expected to raise rates further into 2023, the most likely outcome for next year is a mild recession and an increase in unemployment.
Inflation is currently running far above the Federal Reserve’s inflation objective of 2%, even as it has started to slow in the second half of this year. Most worrisome for the Fed is that inflation has picked up for consumer spending on services; this type of inflation tends to be sticky, and the central bank is concerned that without responding aggressively, high inflation could be a part of the economy for years to come.
The Fed has one primary tool to cool off inflation: higher interest rates.
By making it more expensive for consumers and businesses to borrow, higher rates weigh on demand within the economy, particularly for interestrate sensitive industries like housing and business investment. This, in turn, leads to a slowing in economic growth and lower inflation.
Fed tries for ‘soft landing’
The Fed has already raised rates aggressively this year, increasing its key short-term policy rate — the federal funds rate — from essentially zero at the beginning of 2022 to almost 4%. Another big increase is likely at the Federal Open Market Committee’s next meeting in mid-December, with further rate increases in early 2023.
Long-term interest rates have also increased with Fed policy moves and high inflation. For example, the interest rate on a typical 30year mortgage has risen from below 3% in mid-2021 to above 7%. This has made it much more expensive to buy a home and has led to a steep contraction in the housing market. Both sales of existing single-family homes and new single-family home construction have fallen by about 30% since early 2022, a big reason why economic growth has slowed this year relative to 2021.
More and more parts of the economy will soften as the Fed continues to raise interest rates, such as business investment and consumer purchases of bigticket items like appliances.
This will result in smaller job gains and slower growth in household incomes, creating further drag. The Fed is hoping to slow economic growth enough to push inflation back down to 2% without leading to economic recession — a broad-based decline in activity across most parts of the economy, including widespread job losses.
But with inflation that is still close to its highest levels in 40 years, including strong services inflation, and aggressive Fed interest rate increases in 2022 with further rate hikes to come, the ability of the central bank to pull off this type of “soft landing” is low.
A spring recession?
PNC views the most likely outcome for 2023 as a recession starting in the spring.
The good news is that any recession next year should be mild, especially compared to the last two U.S. recessions.
Factors that should limit the downturn are low levels of consumer debt and good credit quality, a strong financial system in large part due to reforms enacted after the Global Financial Crisis, and restrained homebuilding over the past decade and thus no oversupply of housing. In addition, businesses may be reluctant to lay off workers during any downturn given current hiring difficulties; that would limit the loss in household incomes and the associated drag on consumer spending.
PNC expects real gross domestic product to contract by a little more than 1% next year, much milder than the 4% decline during the Great Recession in 2007 through 2009 and the almost 10% decline during the Viral Recession of 2020.
PNC expects widespread jobs losses next year and the unemployment rate — which was near a 50-year low at 3.7% in October — to move above 5% by late 2023.
While this would be painful for millions of families, this peak unemployment rate should be much lower than the 10% rate in late 2009 and the almost 15% rate in April 2020. The economy should then start to recover in late 2023 as much lower inflation and a deteriorating labor market lead the Fed to start cutting interest rates, boosting borrowing and economic activity.
This forecast is consistent with one of the most reliable predictors of recession, the inverted yield curve. Usually interest rates on long-term U.S. government debt are higher than those on short-term government debt. But ahead of recessions, this relationship flips, or the yield curve inverts, as short-term interest rates move higher because of Fed tightening while long-term rates move lower because of concerns about a weak economy and lower inflation.
That’s what’s happening now, with interest rates on short-term government debt above those on longterm debt, pointing to recession next year.
But a recession is not inevitable. It is possible that the Fed could manage to pull off its very difficult task and slow inflation without pushing the economy into contraction, especially if gets some good luck, such as a quick resolution in Ukraine that brings down energy and food prices.
PNC puts the probability of such a soft landing at around 35%. But the most likely outcome for next year is a short and mild recession, with a brighter outlook for 2024 and beyond.