The threat of a U.S. recession remains alive in 2023. The consensus estimate on the probability of a meaningful downturn in the American economy in the next 12 months is at 65%, according to Goldman Sachs Research. But our own economic analysis rates that probability much lower, at 35%. David Mericle, our chief U.S. economist, and Alec Phillips, our chief U.S. political economist, elaborate on that lower risk and answer some of the big questions facing the U.S. economy in 2023 below:
Why might the U.S. economy avoid recession in 2023?
David Mericle: Our probability of a recession over the next 12 months stands at 35%.
Part of our disagreement with consensus arises from our more optimistic view on whether a recession is necessary to tame inflation. We think that a continued period of below-potential growth can gradually rebalance supply and demand in the labor market and dampen wage and price pressures with a much more limited increase in the unemployment rate than historical relationships would suggest.
Additionally, while the Fed tightened financial conditions substantially last year, the impact on GDP growth is likely to diminish this year. Like other macro models, our analysis shows that the peak impact of rate hikes on GDP growth is front-loaded. In other words, the drag on U.S. GDP growth from recent aggressive Federal Reserve policy will fade as 2023 progresses.
Will we continue to see a drop in the job-workers gap?
David Mericle: Yes. We estimate that our jobs-workers gap — total labor demand (employment plus job openings) minus total labor supply (the size of the labor force) — has fallen from a peak of 5.9 million to 4 million. All of the decline in labor demand so far has come from a decline in job openings — a drop that is much larger than any in U.S. history seen outside a recession — rather than in employment.
While this is encouraging, we estimate that the gap needs to shrink to 2 million to be compatible with a more sustainable rate of wage growth. We expect the gap to narrow steadily this year due mainly to a further drop in job openings, but also due to a limited increase in the unemployment rate to just over 4%. The latest data tells us that job openings are still falling but the layoff rate and initial jobless claims remain very low.
What will happen to wage growth in 2023?
David Mericle: The continued strength in wage growth likely reflects both the tightness of the labor market and demands for larger cost-of-living adjustments in a year when further inflationary shocks pushed headline CPI inflation to an eye-popping peak of 9%. We expect both of these upward pressures on wage growth to diminish in 2023 as the supply-demand imbalance in the labor market continues to moderate and headlines about inflation spiking to new highs give way to headlines about inflation falling and a recession possibly looming.
By the end of 2023, we expect wage growth to slow from over 5% to about 4%. This would still be a bit too hot, but any sizeable drop would provide Fed officials with a proof of concept for the idea that gradual labor market rebalancing can dampen wage and, eventually, price pressures without a recession.
Will inflation come down in 2023?
David Mericle: Supply chain recovery and the deflationary impulse in the goods sector that it promised to bring took much longer than we expected but they have finally arrived. We expect this ongoing process to push core goods inflation negative next year, driving most of the decline in overall core inflation.
Will the Federal Reserve cut the funds rate?
David Mericle: We expect the FOMC to deliver three 25-basis-point rate hikes in February, March, and May and then to hold the funds rate at 5-5.25% for the rest of 2023. There are two possible rationales for cutting the funds rate in the future, but we don’t see either happening.
First, we are doubtful that the goods-driven decline in inflation that we expect in 2023 would be sufficient to give the FOMC confidence that inflation is moving down in a sustained way, which Fed Chair Jerome Powell has said is the criterion for cutting. In fact, I’m skeptical that the FOMC will cut just because inflation comes down. If tighter monetary policy succeeds in reducing inflation, I think the more natural path is to just leave the policy rate unchanged until something goes wrong.
The second and more likely rationale for cutting at some point would be that the economy is entering recession or threatens to do so without an easing in monetary policy. We have cuts in our forecast over 2024-2026, but we do not intend for the timing to be taken literally and instead think of our path of cuts as a placeholder for an uncertain future date when something goes wrong.
Will U.S. Congress enact substantial fiscal policy changes in 2023?
Alec Phillips: Two factors could in theory lead Congress to pass fiscal policy changes with a meaningful macroeconomic impact. First, a recession could trigger a countercyclical policy response as it did during the last three recessions. However, as David outlined, we don’t see a recession as the base case. Even if the economy enters recession, a countercyclical fiscal response is far from guaranteed, as divided control would make it harder for Congress to respond to a downturn, and any recession that might occur would likely be far milder than the downturns that led to substantial fiscal responses in 2008-09 and 2020-21.
Otherwise, the debt limit deadline is arguably the greatest political risk next year, and we expect it to rival the 2011 episode in its disruption to financial markets and the economy. While it could lead to spending cuts, here again, the odds lean against substantial changes. Congressional Republicans are inclined to seek some type of spending cuts in return for an increase in the debt limit. In 2011, these demands resulted in caps on discretionary spending over the next decade that would have reduced spending by 1.2% of GDP over that period, though Congress softened the cuts several times along the way. However, we expect President Biden to reject attempts at negotiation, and we would be surprised if Congress approved more than half as much fiscal restraint next year as it agreed to in 2011.