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Summary:

Real GDP grew at a 2.9% rate in the third quarter of 2022 due largely to a lower trade deficit. Consumer spending cooled in the third quarter but preliminary data suggests that consumers will post stronger end of year spending. Consumer spending is now fueled by increased credit card debt and lower savings rates, even as interest rates climb. This relationship is not sustainable, which is a key reason for predictions of a recession in the first part of 2023. The Fed is aiming for a “soft” economic landing with a return to sustainable inflation without tipping the economy into a recession. A consensus is building that continued increases in the Fed fund rate will be necessary well into 2023, making a soft landing less likely. High interest rates and a declining economy would be very bad news for stocks.

The labor market is too strong for the Fed to stop increasing interest rates. The unemployment rate is 3.7% and a three-month moving average gain in payrolls is 272,000. Average hourly earnings are picking up with a 5.1% year-over-year gain reported in November. These strong labor market indicators occurred even though the Federal Reserve Bank hiked the Fed fund rate from 0.13% in January of 2022 to 3.88% in November. The resilient labor market is likely to prompt the Fed to increase the Fed fund rate by 50 basis points in December and a 25 to 50 basis points in January. Rate increases will be smaller but will continue in 2023. Normally, a strong reaction to higher interest rates occurs with lags from twelve to eighteen months, suggesting that the full effect of rate hikes in 2022 will not occur until 2023. The Fed fund rate is likely to reach 5.5% by the end of 2023 unless a significant slowdown occurs.

Inflation likely peaked at mid-year in 2022 but the Fed’s key measure of inflation remains well above the 2% target. The Personal Consumption Expenditure index (PCE) gained 6% on a year-over-year basis in November and the core PCE increased 5%. A neutral Fed fund rate is likely to be about 4.5%, based on the 2% inflation target and 2.5% potential real GDP growth. While the Fed is taking a contractionary direction, it may require additional increases beyond a 4.5% rate to have a significant impact on consumer and investor decisions. Meanwhile, the Treasury yield curve is inverted, fueled by a demand for longer term securities based on the view that interest rates will decline in the future. Often, an inverted yield curve signals a recession, but in the current context it likely reflects a view that the Fed will be successful in defeating inflation.

The first half of 2023 should be the focal point for an economic slowdown. The economy is struggling with high interest rates, eventual slowing of the labor market, and slumping consumer and business sentiment. Historic levels of consumer credit card debt, lower stock market valuation, slowing housing prices, strong dollar value, and a global economic slowdown all work against U. S. economic growth as we go into 2023. A recession is not inevitable but chances of a shallow recession are at least 50-50. New pandemics, wars, global trade disruptions, or dramatic increases in rates would change this view.