A Look at What’s Ahead for the 2023 Economy
As we turn the page on a new year, it is a good time to think about the economy and the world going forward.
The following is my 2023 outlook for the U.S. economy. This outlook is built on three possible outcomes, or drivers, and each is weighted for your consideration. There is no real science behind the weights, but they primarily rest on my 40+ years of professional experience.
2022 – A Quick Review
Let’s start with a quick review of major economic outcomes for 2022. It was certainly a year of volatility as GDP growth registered contractions in both the first and second quarters, followed by strong growth in the last half of the year. The Atlanta Federal Reserve’s GDP Now data shows us that “real” GDP contracted at a -1.1% annualized pace followed by growth of 3.4% over the second half of the year. This leaves us with growth of +1.2% for a year of weak overall real economic growth, as the longer-term average growth in the U.S. has been +3.2%.
Inflation, on the other hand, strutted its stuff all year, with the latest all-in CPI data showing a 7.1% inflation rate for 2022. On average, over the long term, U.S. inflation has been 3.7% annually,1 so 2022 will go down as a year of economic stagflation when inflation was strong and growth was weak. This was my top economic expectation for 2022.
During 2022, the nation’s financial markets swooned. Both stocks and bonds struggled to provide positive returns, and most major indexes showed negative results.
One idea that I communicated earlier in 2022 was that the year would prove to be one of financial risk, and 2023 will prove to be a year of higher-than-normal business risk. I stand by that view.
2023 Key Points
Just because we have turned a page on the calendar doesn’t mean we are facing a brand-new economic environment. However, staying true to my process and staying disciplined by weighing the available evidence, I believe we may see an economic recession unfold over the next year. I have been suggesting the probability of a recession has been rising, as the Federal Reserve has become serious about monetary policies fighting inflation. While recession is only a possibility, if it does occur, I suggest and outline below why it will probably be a shorter, less-powerful cousin of the recession we saw in 2007 to 2010. Lastly, I cover my view of the possible outcomes if we don’t enter a short recession.
The Fed in the Dock
Monetary policies matter a lot. The Fed has fostered and supported very easy monetary policies since 2008 the majority of the time. During that 14-year period, interest rates fell to 0% and M2 growth rates were robust on balance, according to the St. Louis Federal Reserve. It’s little wonder, then, that eventually inflation started to come back to life. Since the first 0.25% rate increase last March, the Fed has accelerated its tightening program.
In theory, the economic impact from the Fed’s policy of raising rates may not be fully felt until the fed funds rate reaches “terminal” status, or above overall core inflation rates. Core inflation (CPE) is now 4.7%,2 and the fed funds rate, after all the rate increases so far this year, is at 4.5%. We shouldn’t expect a major impact on economic activity from the Fed’s policy moves yet. In practice, monetary policy shifts normally don’t impact economic activity for up to six to 12 months following the policy change. We should expect the full impact of the Fed’s multiple 75-basis-point moves (which were launched starting in June last year) to impact economic activity sometime in mid-2023.
I suggest the Fed isn’t done raising rates, depending on what happens with inflation over the first few months of 2023. A 5%+ fed funds rate seems to be in the cards. At that level, I believe Fed policies will start to bite the economy and slow overall growth meaningfully.
In economics, as is the case with most meaningful events in life, there are no “solutions,” only trade-offs. The potential negative of monetary policies designed to fight inflation pressures include the possibility of the Fed “overcooking” policies, which in the past has typically led to recessionary environments.
I have written at length about this forecast and stand behind that view. I have been raising the probability of a recession occurring sometime “over the next year,” and that probability now stands at 50%+. Of my main “thematic” forecast probabilities for 2023, recession remains at the top of the probability list.
How often has the economy been in recession in the past? According to the people who decide whether we are in or out of recessions, the National Bureau of Economic Research, the U.S. economy has been in recession 13% of the time since the end of World War II. With an outlook probability of 50%+, you can see that I believe the risk of a recession occurring sometime in 2023 is higher than normal.
Weight of the Evidence
Why do I believe a recession will occur sometime over the next 12 months? I have relied on three major models, which have been reliable in their ability to call an upcoming recession. Discussion of these three models follows.
- The Shape of the Treasury Yield Curve (see U.S. Treasury Yield Curve Spread chart). Historically, when the 2-year Treasury note is yielding more than the 10-year note, a recession has followed consistently one to two years following the initial inversion. This cycle, the 2-year Treasury yield was initially higher than the 10-year yield in April. Using history as our guide, we can say that this indicator suggests a recession should occur in 2023 or early 2024. As noted above, the severity of the current inversion is the most significant we have seen since the double-dip recessions that occurred more than 40 years ago. As validation of the yield curve issue, the fed funds rate is now above the 10-year Treasury yield, a normal precursor to an upcoming recession (see U.S. Yield Curve & Business Cycle chart).
Source: Yardeni Research
Source: Yardeni Research
- Six-Month Rate of Change of the Leading Economic Indicator Index. Historically, when the LEI has declined by 3% as compared to the LEI six months prior, a recession has been not far behind (see the Conference Board chart). The 3% decline rate occurred slightly prior to the start of the three previous recessions. However, in all cases, a recession started within 12 months of the 3% deterioration “trigger.” The 3% trigger was reached earlier this year, indicating that the probability of a recession occurring sometime in 2023 is a reasonable assumption.
- The ISM PMI Indexes. These indicators measure business momentum. They are polls conducted by the Institute of Supply Managers. The polls ask various questions of companies related to the state of their current business compared to the state of their business 30 days prior. There are separate surveys for manufacturing and service-based companies. As noted in the U.S. Purchasing Managers Indexes chart, the manufacturing PMI index (blue line) is now below 50, which indicates negative momentum on the manufacturing side of the U.S. economy. In addition, the services PMI index (non-manufacturing indicated by the red line) is still positive at 56.5, but a downward trend has been obvious since the first of 2022.
Source: Yardeni Research
The weight of the evidence noted above tells me that the probability of the economy falling into a recession over the next 12 months is higher than normal.
Recessions Occur for Reasons
Recessions are a natural part of the market-driven business cycle and part of the price we pay for a market-driven economy. Excesses occur over time. In the current state, demand outstripped supply for various reasons, driving prices upward, which creates weakness in many segments of the economy and an unstable environment. This is where we currently see the U.S. economy.
Not All Recessions Are Alike
Recessions have historically been short periods when things slow and excesses get washed away from the economic system. Recessions vary from one another in their length and intensity and are driven by the imbalance that needs to be washed from the system. I suggest there are two types of recessions our economy has faced in the past—income statement recessions and balance sheet recessions.
Many deep recessions occur because economic debt structure is too high and unstable. Take the deep Great Recession of 2007 to 2009. This was a balance sheet recession that resembled problems associated with the Great Depression of the 1930s. There was too much debt within the economy, much of which became unserviceable. Consider the following debt levels of the economy in 2007 versus those same levels prior to the early 1990’s recession (income statement, or light recession) and today.3
|Debt Service to Household Income||11.8%||13.2%||9.7%|
|Bank Loans-to-Deposit Ratio||0.90x||1.03x||0.62x|
As noted, consumers have the capability of more easily handling debt service payments now as compared to prior to the 2007 recession. The amount of household income needed to make payments on outstanding debt is 36% lower now as compared to 2007.4 Additionally, banks were highly levered in 2007 when measured by the loan-to-deposit ratio of the average bank, which showed that the average bank was “loaned up” with loan levels higher than deposits, and loan losses were much more damaging to the system than is the case today.
What of businesses? Are they stressed? Over the period of 2010 to 2020, business debt-to-equity ratio ranged from 47% to 39%. As of Sept. 30, 2022, that ratio stands at 41%,5 suggesting that the average business is under-levered compared to the range over the previous 10 years.
I don’t see tremendous financial stresses currently occurring in our financial system. This leads me to the view that if we see a recession in 2023, it will probably be a light, quick recession, similar to the recession of 1990, than the deep, prolonged experience of the Great Recession of 2008 to 2009.
Therein Lies the Problem
While I don’t see a debt servicing problem, I do see a pricing problem—inflation remains high. If we do see a recession, that problem should be modified. As of November 2022, headline CPI is 7.1%. Over the previous four recessions (1980, 1981-1982, 1990-1991, 2001, 2007-2010), inflation declined by an average of 2.68%.6 The last time our economy experienced an inflation problem (early 1980s), the Fed was prompted to raise interest rates aggressively. This threw the economy into recession, but inflation declined by 6.29% during the recession of 1981 to 1982.
This is the silver lining of an upcoming light recession, one that I contend is being engineered by the Fed’s monetary policies. Even if we only see an average decline in inflation during the next recession, we could look for headline CPI to be 4.4% by the end of that recession. Or, if we apply the 1981 recession model to the view, inflation could fall to 0.8%. The point here is that if we see a recession, inflation will fall more rapidly than might be the case if we simply avoid a recession and struggle through.
Are there alternative scenarios other than a recession occurring sometime in 2023? As noted, I am carrying a probability (based on our modeling output) of a recession occurring at 50%+, which leaves a lot of room for something other than recession being a main driver in economic activity in 2023. I have discussed the other three probabilities in former writings, so I won’t go into as much detail, but two other scenarios are both valid and easy to support.
- Stagflation Continues. It is highly possible that the environment we are currently in (lower-than-normal GDP growth and higher-than-normal inflation rates) could remain throughout 2023. If this turns out to be the case, I suggest the Fed will remain vigilant in fighting inflation, driving interest rates higher than our core outlook suggests, and the eventual downturn would probably be deeper and longer than if the recession occurs over the next 12 months. I assign a probability of 25% to this scenario.
- Soft Landing. Under this scenario, Fed policies would turn out to be “just right”—not too hot or too cold. A recession would be averted. This view allows for a “rolling recession” to occur, where segments of the economy enter and then leave business contractions, not on an outright, macro basis, but rather on a micro basis. Final demand growth rates remain positive in this view, but growth rates on a macro scale remain subdued. An example of this outcome is currently happening in the housing market. With rising interest rates and pricing, new housing supply is being cut rather dramatically, and home builders are reeling. This rolling recession outcome could eventually bring inflation down, but the process would possibly be longer and more painful than a quick recession. I currently assign a probability of 20% to this outcome.
Below find macro assumptions and outcomes during 2023 based on the three probable scenarios outlined above.
|Light Recession||Stagflation Remains||Soft Landing|
|GDP (total year)||1%-2%||1%-2%||2%-3%|
|Inflation (end of year)||3%-4%||5%-6%||4%-5%|
|Fed Funds (end of year)||4%||6%||5%|
|Unemployment (High Target)||5.5%||4.0%||3.5%|
Will we see some kind of economic recession in 2023? I believe odds suggest that we may. On the other hand, factors may assert themselves that could generate a soft-landing environment. Or, we may simply see the continuation of the stagflation environment that has been dominant over the last year.
In the end, I come back to my earlier view that 2022 was a year of higher-than-normal financial risk. 2023 may indeed prove to be a year of higher-than-normal business risk.
1St Louis Federal Reserve, monthly data, year over year from 1970-2022
2Bureau of Economic Analysis
3,4,5,6St. Louis Federal Reserve
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