As we look back on 2022, it would be fair to tap classic literature and say that 2022 was a tale of two economies. In the first half of the year, the economy was somewhat terrible, with negative GDP growth in both quarters, while the last half of the year we saw very strong GDP. 22Q3 growth was about 3.2%, and while we don’t yet know what 22Q4 will look like, early estimates suggest 2.5%-3.0%. However, the important thing to remember is that the economy was not nearly as bad in the first half of the year as the numbers suggested, while similarly the second half of the year was not nearly as strong as the numbers may imply. When taken together, the picture is of an economy that is slowing somewhat, not disastrously, but certainly starting to moderate from the frenetic post-Covid pace. We see this in a number of measures; for example, job creation has steadily declined throughout the entire year, wage growth appears to be slowing and the manufacturing sector is slipping into recessionary territory.
It's important to remember that this economic slowing is a feature and not a bug of Fed monetary policy. High interest rates are intended to slow inflation by decreasing consumption, and how long the Fed keeps rates at these higher levels will depend on how quickly and how much inflation declines. We’ve already seen some inflationary pressures start to ease. As fuel prices have come down, shipping and trucking costs have declined, and the percentage of household income spent on gasoline has eased. Generally, increases in the cost of goods have slowed, so, for example, new car prices and used car prices are both falling. Consumer electronics prices and availability have stabilized as the chip shortage ebbs, and food prices, with a few exceptions, are generally not rising. Goods prices are expected to contribute to deflation going forward. The larger problem now is services inflation, a majority of both GDP and consumer spending. The shortage of available workers continues to plague the service economy and push the cost of services up; everything from airline tickets to haircuts. To address continuing services inflation, the Fed is likely to increase rates further in the first quarter of 2023, and then keep them at that elevated level through all or most of the year and see how services inflation responds.
Given the current economic trajectory and the fact that interest rates will remain elevated well into 2023, it certainly seems likely that the economy will continue to weaken, the big questions are by how much and how quickly does that happen? Will we see a “soft landing” or a recession, and if we have a recession, will it be a mild one, or one that is relatively deep? While most economists expect a recession in 2023, some are predicting the hoped-for soft landing. That said, the difference between these two alternatives is likely to be small. Those expecting a recession anticipate a mild one, with unemployment rising two to maybe two-and-a-half percentage points and no calendar year 2023 GDP growth. Those forecasting a soft landing see unemployment rising by one percentage point and GDP growing anemically.