US economic outlook: economy is defying the odds, but markets should curb their enthusiasm

We now see the US economy growing 2.2% in 2024, 1.1ppts higher than our prior forecast. Headline CPI inflation is expected to average 2.7% in 2024 after a 4.1% increase in 2023. With disinflation making strong progress, we expect the Federal Reserve to kick-start a cautious easing cycle in the second quarter of this year. However, the strength of growth and upside risks to inflation render unlikely the rapid easing cycle that is being priced in futures markets. We expect the Federal Open Market Committee (FOMC) to begin reducing its policy rate at the May meeting, easing by 75 basis points (bps) this year while the 10-year Treasury yield picks up to 4.2% by year end.

• A strong handoff into 2024 prompts a revision in our US GDP growth forecast, up 1.1ppts to 2.2% in 2024.
• Cooling inflation and a softening labour market support our call that the Fed will begin gradual cuts to policy rates from Q2 2024.
• We see three 25bps cuts from May, the pace reliant on growth trends.
• We expect robust growth and still-elevated policy rates in H2 will support the 10-year Treasury yield rising to 4.2% by the end of 2024.

Table 1. Key US forecasts

The faster-than-expected improvement in inflation dynamics has given the Federal Reserve greater flexibility in the case of a sudden economic slowdown. Core PCE inflation, the Fed's preferred inflation gauge, slowed to below the 2% target on a six-month annualized basis in the final two months of 2023 as disinflation made strong progress in both the goods and services components (see Figure 1).

Figure 1. US PCE inflation components

Headline CPI inflation ticked up by 30bps to 3.4% at the end of 2023, but the disinflationary process is poised to continue this year. Core CPI inflation has fallen by 270bps from its 6.6% peak to end 2023 at 3.9%. With core goods inflation flat in recent months, the focus is on sticky core services prices. Heading into 2024, shelter inflation was elevated at 6.2%, but we expect disinflation will bringing shelter down to nearly 4.5% by the end of the year, shaving more than 50bps off annual core CPI inflation.

The Fed pushed back against market enthusiasm at the first policy meeting of 2024 by holding rates steady and affirming the need for continued disinflation progress before they begin easing. However, both the FOMC statement and communications from Chair Powell saw the Committee's bias shift from hawkish to balanced, suggesting that the FOMC will not ease policy rates until it has "gained greater confidence that inflation is moving sustainably toward 2%".

Figure 2. Prior US Federal Reserve easing cycles

On the one hand, monetary policy is the tightest it has ever been preceding recession (see Figure 2) and credit conditions remain tight. On the other hand, US GDP growth printed at a well-above consensus 3.3% in Q4 2023 and geopolitical risk such as Red Sea shipping attacks will likely keep inflation risks elevated. We expect the Fed to opt for caution in March and only commence easing at its May meeting, probably at a 25bps, every-other-meeting pace until Q4 2024. We see the easing cycle picking up steam next year, ultimately lowering the policy rate to 3-3.25% by the end of 2025.

The first jobs report of 2024 delivered a blowout 353 000 increase in payroll growth, well above expectations, while the unemployment rate remained steady at 3.7%. Meanwhile, initial claims for unemployment insurance remain near historic lows at just 207 750 in early January. Job vacancies were elevated at 9.0 million in December, 1.8 million above their January 2020 pre-pandemic level.

Figure 3. US hiring, annual rate and hours worked

The Fed is concerned by strong wage growth, up by 0.6% month-on-month and 4.5% y-o-y. Notably, the increase was distorted by a sharp drop in the average workweek, which has declined to near-recessionary levels in recent months. Both the slowdown in the average workweek and hiring (see Figure 3) are signals that labour market strength is likely unsustainable. We expect a cooling in labour market conditions to support a gradual reduction in the policy rate.

Robust consumer spending (2.8% seasonally adjusted annualised growth) and business investment (+2.1% seasonally adjusted annualized) were key to the high Q4 2023 US GDP growth. The US consumer entered 2024 on a solid footing: real personal income rose at a 3.1% annualized rate in December 2023, the fastest since September 2021, as inflation continued to decline, supporting real earnings. The US savings rate remained historically low at 3.7% at the end of the year as well, implying households are confident spending amid healthy balance sheets.

Figure 3. Real personal income less transfers (12-month annualised pace)

The improvement in consumption patterns is corroborated by a revival in sentiment surveys, with the University of Michigan's consumer sentiment index rising to 78.8 in January – its highest level since July 2021. Inflation expectations, meanwhile, continue to plummet. The expected inflation rate next year fell to 2.9% in January from 3.1% in December and 4.5% in November. Long-term expectations also remained anchored at 2.8%.

However, corporates are still struggling with the adjustment to the higher rate environment. While the ISM manufacturing survey eked out a 0.7ppt increase in December, it remains in contraction at 47.4. The ISM services survey has declined in three of the past four months, down 2.1ppts in December to 50.6. We foresee higher borrowing costs eroding corporate profit margins and slowing hiring growth, leading to economic weakness in H2 2024, although the onset of the Fed's easing cycle will likely guard against a deeper slowdown