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U. S. GDP increased at a 2.1% annual pace in the second quarter of 2023, according to the revised Bureau of Economic Analysis. Second quarter growth almost matched the first quarter’s 2.0% rate. Growth in 2022 was a disappointing 0.9%, with declines of real output in the first half of the year offset by strong gains in the second half. GDP growth in 2023 may again be a tail of two-halves. Trend growth of around 2% may spill into the third quarter but the year is likely to end with much slower growth in the fourth quarter. The full weight of Fed rate hikes, tighter lending standards, labor union strikes, and a potential round of further rate hikes may fall on fourth quarter GDP growth. While a slower economy later in 2023 is likely, predictions of a recession have taken a turn. Analysts likely underestimated the lag effect of interest rate increases and the resilience of consumer spending. A softer economy in 2024 with a potential shallow downturn tends to be the more likely scenario.

Inflation measured by the core PCE, the Fed’s key target measure, is currently running at 4.2% on a year ago basis. Inflation pressures are easing based on lower rates in recent months. The annual inflation rate in the second quarter was only 2.5% compared to a 4.1% annual rate in the first quarter. Market expectations about future inflation have fallen but there are plenty of inflation drivers left in the economy. Consumers are spending at a higher rate than the rate of increase in disposable income, especially for services. Spending is also supported by a higher use of credit. The savings rate is relatively stable around 4% but it remains well below the longer term average of 7.5%. A reduction in oil supply through at least the end of 2023 by Saudi Arabia and Russia will send prices higher while the U.S. government is cancelling oil leases in Alaska and continuing a war of fossil fuels. Wage gains by organized labor and a new emphasis on higher wage demands will also put pressure on prices going forward. It is likely that the Fed’s job is not done and at least one more rate increase will likely occur by the end of the year.

The labor market is showing signs of slowing based on lower numbers of jobs openings per unemployed. The job opening turnover rate, measured by job openings relative to the labor force, is declining. Monthly payroll gains have fallen to 150,000 on a three-month moving average, which is almost 80,000 lower than the average in 2022. While openings are falling, layoffs that normally lead a downturn have not yet picked up and the unemployment rate of 3.8% remains close to full employment. Even as the labor market slows wage demands are increasing, especially for organized labor. A slower labor market in the second half of 2023 is likely but an increase in layoffs will be needed to signal significantly lower inflation pressure.

The yield curve remains inverted, largely due to lower expectations for inflation and interest rates in future holding periods. Investors believe the Fed policy of higher Fed fund rates will reverse when the economy weakens. Short term investments today are expected to be reinvested at lower short term rates in the future, prompting investors to lock in longer term rates today. The higher demand for long term rates drive prices higher and rates lower at the long term end of the yield curve. Jitters over the future of the stock market and a flight to safety by global investors will also support demand for longer term bonds, keeping long term rates from rising much higher.