Economic outlook 2023: Inflation eases, recession maybe

Most analysts are willing to commit to a slowdown in inflation in 2023, but a recession remains a trickier call. 

“I think the bond market is right, a recession is coming,” said Liz Young, head of investment strategy at SoFi, “and the economic indicators reinforce that message.”

The debate over the likelihood of a recession “is worse for markets than simply having a recession and answering the question,” she said.

She added, “We’re late cycle. The next spade in my hand says: I don’t see how we get back to early cycle without a recession. I just don’t think we’ve seen enough evidence of it to convince market valuations yet.”

A mild recession next year remains “the most likely path,” said Scott Anderson, chief economist at Bank of the West. “But in a nod to a more hawkish Fed and a higher interest rate environment, the economic growth risks are still very much weighted to the downside, and we cannot rule out a more severe recession taking hold next year.”

Bank of the West sees a 70% chance of recession in 2023, up from 65% before the latest Federal Open Market Committee meeting.

A modest recession remains the base case for Wells Fargo Securities Chief Economist Jay Bryson, Senior Economist Sarah House, International Economist Brendan McKenna and Economist Charlie Dougherty.

“We anticipate that the elevated rate of inflation, which has eroded household real income, and the degree of monetary tightening, which the FOMC has already undertaken with more to come, will cause the U.S. economy to slip into a modest recession beginning in mid-2023,” they said in a report.

Other factors will impact the economy, they said. Although real income has declined, households have tapped savings to continue spending, “bringing the personal saving rate down to below 3%, the lowest rate since 2005, and by running up credit card debt. Will consumers continue to spend in 2023 at the expense of their long-term financial health?”

They believe the answer is no and consumer spending will “begin re-trenching in mid-2023.”

“Recession risks in 2023 have increased significantly but it is too soon to say that it is inevitable,” according to Brendan Murphy, head of Global Fixed Income, North America at Insight Investment.

“One important feature of the current environment is that both consumers and businesses have come into the current rate hiking cycle with relatively strong balance sheets which should provide some cushion,” he said. Businesses have been able to pass on price hikes to consumers.

The first impact of higher rates is now seen as the housing market weakens.

“The resilience of the consumer in the face of higher costs and a deteriorating labor market remains the key question for whether or not we see a sharp economic downturn in 2023,” Murphy said.

And while the labor market has been “resilient,” he said he expects “deterioration in the coming months.”

Still others see a mixed year.

“Most of our strategists agree that 2023 will be a ‘a year of two halves,’ one bullish, one bearish,” with inflation declining faster than expected in the first six months, BCA Research said in a special report.

But recession outlooks differ. “The first camp believes falling inflation will incorrectly stir up hopes for a soft landing, resulting in a bullish start to the year, followed by a bearish second half and a mild recession in 2024,” BCA said. “The second camp believes the effects of monetary policy tightening will be felt early in 2023 dragging down equity prices before they rally in late 2023, resulting in a bearish H1 2023 and bullish H2 2023.”

Stonebridge Capital Advisors Chief Economist Daniel Laufenberg agrees there will be two distinct halves to the year.

“The outlook for the year is now expected to be divided into two parts,” he said, “with something similar to stagflation being the theme of the first half and a substantial recession being the theme of the second half.”

Rates will have to be higher than “expected to fight the prospect of stagflation,” Laufenberg said. “The recession will cause inflation to slow to a sustainable level closer to the Fed’s target. As a result, interest rates will have an opportunity to roll over in the second half.”

But one result of the “rollercoaster path of interest rates” will be “volatility,” Laufenberg said.

“The aggressive action from the Fed in 2022 has laid the foundation for inflation to return to target in due course,” said Tom Garretson, fixed income senior portfolio strategist at RBC Wealth Management. “The sharp rise in yields across the fixed income landscape that played out in 2022 will give way to the opposite in 2023.”

The fed funds rate remains accommodative, said Megan Horneman, chief investment officer at Verdence Capital Management. “We believe the peak in the fed funds rate will be achieved in mid-2023 (likely June). Our base case is for the Fed funds rate to peak at a range of 5.25-5.50% and then the Fed to pause and assess the economic outlook.”

Before the next FOMC meeting, she said, the economy will weaken and inflation will ease, allowing the Fed to raise rates 25 basis points at each meeting in the first half.

Inflation will remain above levels seen in the “past few decades,” between 2.5% and 3.5% for the decade, Horneman said, as the federal deficit worsens. “We will continue to have supply constraints in commodities (especially energy) and we have a Federal Reserve balance sheet ($8.6 trillion) that is bigger than the economies of Japan and Germany combined.”