US economic outlook: peak interest rates are soon to apply the brakes to growth

The completion of the 2022-23 interest rate hiking cycle has set the stage for a material US economic slowdown in 2024. Blowout Q3 GDP growth has lifted our forecast for 2023 GDP growth to 2.4%, but we expect the strain of monetary policy will slow growth to just 1.1% in 2024. Headline inflation is expected to continue its moderation next year, easing to 2.7% from 4.2% this year. However, sticky and persistent inflation will limit the degree of policy easing, and we see just 75 basis points of rate cuts in 2024. We expect the 10-year Treasury yield to moderate further to 4.2% by the end of next year.  

• We expect US real GDP growth to slow materially to 1.1% in 2024 from 2.4% this year.
• Further slack is needed in the labour market next year for inflation so come down to the Fed's 2% target.
• We anticipate the Fed to ease policy rates by 75bps in 2024, but see risks skewed to greater cuts if growth slows more sharply than our forecast.
• We expect the 10-year Treasury yield to settle at 4.2% by the end of 2024 as inflation remains above target and policy remains restrictive.

Inflation is no longer running wild, but is not yet fully tamed. Headline CPI inflation cooled to 3.2% at the beginning of Q4 and we are optimistic that more is to come, but services inflation is proving persistent. We now see headline CPI inflation averaging 4.2% in 2023 and 2.7% in 2024, 20 basis points higher than our prior forecast but still soft enough to support some easing in policy rates. The decline in October 2023 inflation was largely due to a 2.5% decrease in energy prices in the month. Core CPI inflation moderated further to 4% - its slowest pace since September 2021. While core goods inflation is roughly flat, core services inflation remains elevated at 5.5% - well above its pre-pandemic growth rate of 3.2%, although its slowest pace since the summer of 2022. Shelter inflation – 44% of the core CPI basket – has moderated for seven consecutive months to 6.7% and is well positioned to decline further through H1 2024. Upside risks to inflation will likely persist given a still-structurally tight US labour market and strong growth in real incomes.

Table 1. Key US forecasts

We think hopes for an aggressive easing cycle are premature. The Federal Reserve kept its policy rate unchanged at 5.25-5.5% in November, in line with our expectations, and we interpret the latest FOMC communications as the official end to the hiking cycle. The rise in long-term bond yields has reduced the need for further rate hikes as tighter financial conditions can substitute for a higher terminal policy rate. Our outlook sees a weakening in the economy and moderating inflation allowing the Fed to kickstart its easing cycle in late Q2 2024. However, we think some inflation persistence and the threat of a reacceleration will limit how much the Fed will reduce its policy rate next year, with some scope for further tightening if needed. We expect a gradual reduction in the policy rate of just 75 basis points in 2024 before a further 150 basis points of easing in 2025. Expectations of steeper cuts based on historic comparisons are unwarranted. While some easing cycles were much steeper (see Figure 1), those were triggered by sharp declines in growth, while we expect only a drawn-out (five quarter) slowdown in economic activity.

Figure 1. Prior US Federal Reserve easing cycles

The US labour market remains tight but loosening heading into 2024. The US job market remained tight in November, with payrolls rising by 199,000. The US unemployment rate fell 0.2ppts to 3.7%, still historically low but marginally higher than its 3.4% trough in April 2023. The decline should alleviate fears of crossing the "Sahm rule" recession threshold, where the 3-month moving average of the unemployment rate rises 0.5ppts above its recent low. Wage growth remained at 4.0% in annual terms, which is its slowest pace of growth since the summer of 2021. Job vacancies are following a similar path, falling to 8.7 million in October, which is the lowest number of job openings since March 2021. The vacancies to unemployed ratio also moderated to 1.3 from a peak of 2 in March 2022. Furthermore, the quits rate has fully moderated to its pre-pandemic pace, signaling reduced confidence in the job market. We do not anticipate a sharp rise in the US unemployment rate, and indeed its increase so far has been muted relative to prior cycles (see Figure 2).

Figure 2. Increase in the unemployment rate vs. past cycles

The consumer spending boom is running out of steam. The strain of monetary policy is becoming more apparent. Robust 5.2% US GDP growth (seasonally adjusted, annualised) in Q3 2023, with a sharp 3.6% rise in consumer spending, confirm that households have fared well in the higher rate regime so far. However, real disposable personal income rose just 0.1%, suggesting the spending strength is unsustainable. And with pandemic-era savings largely spent, we expect households to be increasingly constrained by higher interest rates and reduced savings buffers. Personal incomes rose by only 0.2% in October, well below the 0.7% increase in September, while the savings rate increased to 3.8%. For corporates, too, higher borrowing costs are eroding profit margins and firms are increasingly using hiring freezes and modest layoffs to offset this headwind. The ISM manufacturing index was unchanged in October but remained in contraction territory at 46.7. The ISM services index conversely rose 0.9 points to 52.7. We expect the US economy to grow by 2.4% in 2023 and 1.1% in 2024. We look for the 10-year Treasury yield to remain largely unchanged over the next 12 months and settle at 4.2% by year-end 2024.