How will the Fed deal with the twin threats of high inflation and a slowing global economy?
The US economic outlook for 2023 looks set to be a battle between inflation and growth. The Fed remains committed to containing inflation, and monetary policy is expected to be tight for most of next year despite clear signs of slowing activity. Faced with high inflation and a tight labor market, the Fed believes it has no choice but to prioritize its goal of price stability and has publicly embraced the idea that some economic pressure will be necessary to restore low and stable inflation.
But how will the US economy fare when the Fed faces the twin threats of high inflation and a slowing global economy?
There should be a marked slowdown in growth next year due to lower consumption. Private consumption has held up so far this year, offsetting the negative effect of net trade and inventories. But consumption growth is slowing towards the end of the year, and I expect this trend to continue, accentuated by high borrowing costs, tight economic conditions and the expected slowdown in the labor market. Furthermore, the outlook for domestic and external demand has worsened due to the energy crisis in Europe, slowing growth in China and the synchronized tightening of monetary policy by the world’s major central banks.
The convergence of these headwinds will be a major headwind for the US economy next year and slide it into recession. Although the labor market remains tight, there are some signs of a slowdown. Growth in wages has averaged about 400,000 a month so far in 2022, and 4 million jobs have been created. The recovery in the labor market has been much stronger than expected, and job growth remains significantly higher than in the expansion period before COVID. Nevertheless, the data shows that demand for labor is falling, with many companies announcing hiring freezes or layoffs. Wage inflation also appears to have peaked. With the recession, labor market conditions will also worsen.
What does this decline in domestic demand and this deterioration in the labor market mean? They are likely to deal a significant blow to the sustained high inflation we have experienced this year. Headline CPI inflation, at 7.7% year-on-year in September, has fallen almost 1.5 percentage points since peaking in the summer. Most of this deceleration is due to the decline in the petrol/diesel and energy components, but of late there has been progress in the prices of basic necessities. This downward inflation trajectory should continue, at least in the near term, as global demand slows, inventories rise and energy prices stabilize. But while headline inflation is likely to ease further from current record highs, it will still remain at an uncomfortable level for the Fed in the first half of next year, prompting it to keep monetary policy tight.
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