Brace for Recession Next Year. But the Outlook Isn’t All Doom and Gloom.
By Megan Cassella
Jerome Powell and the Fed will keep fighting inflation in the new year./ Barron's Staff Illustration; Bloomberg (1)If 2022 was the year U.S. investors came around to the reality of entrenched inflation and a reactionary Federal Reserve, 2023 will be the year they learn to live with both.
Neither is likely to fade anytime soon.
Next year could see a winding trek toward a mild recession in the second half, the result of the central bank’s quest to chill the labor market and rein in price growth.
Economists expect that the Fed’s continued push to tighten monetary policy and cool consumer spending and business activity will begin to weigh on the labor market by the middle of the year, sparking widespread layoffs and a jump in the unemployment rate.
The loss of income will slow consumer demand as households spend down excess savings and rack up credit-card debt.
Most economists are forecasting sluggish or negative economic growth for the year, and a substantial slowdown in price growth.
But core inflation is likely to stay above the central bank’s 2% target, forcing the Fed to keep rates high through year end.
The upshot is that while the Fed will make progress in 2023 on cooling the labor market and inflation, it will still have work to do when families gather again next holiday season.
“I look at 2023 with a great deal of trepidation,” says Mark Zandi, chief economist at Moody’s Analytics.
“We’re in a world of high inflation and the Fed is on high alert.
And that, historically, has often resulted in a recession.”
Next year’s forecast isn’t all doom and gloom, however, based on Barron’s discussions with economists.
Beyond the hurt inflicted by the Fed’s inflation fight, other potentially positive trends are emerging that will define the post-pandemic economy.
Ongoing labor shortages are likely to prompt companies to devote more resources to automation, while investments made in this area in the past two years should begin to pay off, boosting productivity.
Efforts to decouple the U.S. economy from China will increase in areas deemed crucial to national security.
And industrial investment in everything from U.S.-based semiconductor facilities to research related to wireless supply chains will begin to ramp up, as well, laying the groundwork for reorienting and strengthening U.S. industrial policy, a long-term trend.
“We’re in for a year of transition,” says Joe Brusuelas, chief economist with the economic consulting firm RSM US.
“There’s going to be a little bit of blood in the street next year, due to the unemployment rate increasing, but that’s when firms begin to take smart risks.
Then you enter a cycle of recovery, and then expansion.”
The dominant economic story in 2023 is the likelihood of a U.S. recession.
Seven of nine forecasters canvassed by Barron’s say an official downturn is all but guaranteed, with Goldman Sachs notably bucking this consensus call.
American consumers will determine the path ahead.
For now, they are spending.
Unemployment is low, wages are rising, middle- and high-income households have yet to fully spend down their pandemic-era savings, and low-income families are only just beginning to accrue credit-card debt.
The economy will continue growing as long as consumers can hold on.
“You look across the fundamentals of the economy and they look pretty good to me,” Zandi says.
“Either that argues for no recession, or if we go into one, it would be short-lived.”
The consensus is that consumer demand will peter out within a year.
Citigroup economists expect spending to remain strong at least through the first half of the year.
Sarah House, a senior economist with Wells Fargo , sees the estimated $1 trillion remaining in excess savings being depleted by the fall.
At that point, she says, spending will have to fall to realign with incomes, which will have been held down by high inflation and increased job losses.
Goldman economists think a recession is unlikely because they expect consumer demand to be more resilient.
But if and when consumers run out of spending power, a recession will follow.
Average hourly earnings are key for two reasons: The longer incomes remain healthy, the longer households are likely to keep spending, staving off a downturn.
But continued growth in wages will keep inflation high, signaling how much further the Fed needs to go.
“For the first six months of the year, wages are everything, Brusuelas says.
Services inflation will likely rise through the early months of next year.
That will keep overall inflation elevated even as goods prices deflate—a trend that will accelerate as China drops its Covid restrictions—and falling rent prices begin to show up in government data.
By the fourth quarter, core inflation could still be well above the Fed’s 2% target, and will likely close out the year between 3% and 4%.
Citi economists, who say the economic outlook is “worse than you think,” see the Fed’s preferred inflation gauge ending the year even higher, at 4.3%.
Ongoing labor-market strength that keeps inflation elevated will force the Fed to keep interest rates at a higher level for longer than the market currently expects.
Most economists see the federal-funds rate closing out 2023 above 5%, and potentially in the 5.25% to 5.5% range.
Perhaps most significantly, the economists Barron’s spoke with don’t see any rate cuts on the horizon for the Fed next year.
That view runs counter to current expectations that the Fed will reverse course and lower rates once the economy enters a recession.
But economists warn that the long-awaited “pivot” is unlikely to happen next year because the central bank will be loath to loosen its policy so long as inflation remains elevated—even if that means deeper economic hardship.
Central bank officials will more likely wait to move when they are convinced not only that price growth is slowing, but that it is on its way back down to 2%.
“The most aggressive monetary tightening cycle since the 1980s will leave a visible imprint on the economy in 2023,” Seema Shah, chief global strategist with Principal Asset Management, and her team wrote this week.
“Unfortunately, relief from the Fed will not be forthcoming, even as a probable recession takes shape.”
By keeping rates elevated, the Fed hopes to avoid a drawn-out inflation fight similar to what the U.S. experienced in the 1970s and early 1980, when Paul Volcker was Fed chairman.
“One of the big lessons they’ve learned from Volcker’s experience is that stop-start monetary policy ultimately results in the Fed having to hike rates even higher to lean against inflation, causing more damage in the economy,” says Megan Greene, a senior fellow at Brown University and global chief economist at the Kroll Institute.
While the Fed’s inflation fight will take center stage in 2023, keep an eye out for trends that will shape the economy thereafter.
One is the push toward regionalization, or efforts to reshore supply chains at or closer to home and decouple parts of the U.S. economy from China.
The Biden administration will work to implement the recently passed CHIPS Act, which earmarks nearly $300 billion for boosting domestic production of semiconductors and jump-starting research and development of new technologies such as AI.
That amount of public funding could spark more private investment even as more technology companies look to establish production facilities on U.S. soil.
The CHIPS Act is focused in part on countering China’s influence, and simmering tensions with Beijing are likely to influence the economy next year.
Greene notes that pharmaceuticals could also be under discussion as an industry vital to national security that should be based in the U.S.
One open question is whether U.S.-China tensions could chill the business environment, dragging down economic growth.
“Big firms typically have expansion plans for their operations in China, and now some of that probably gets put on hold because of uncertainty,” says David Dollar, a senior fellow and China expert with the Brookings Institution.
While an economic downturn may lead most businesses to rein in spending, others could look for ways to boost productivity.
“Firms are going to look to get more efficient,” Brusuelas says.
“Due to the labor supply constraint that we’re all facing, we’re going to embark on a period of automation, and the integration of machine learning and artificial intelligence across all sectors of the economy.”
That could pay big dividends in years to come—and prove disinflationary.
Just don’t count on such investments rescuing the economy in 2023.
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