US outlook - Mild recession to see inflation fall
Fed close to peak but far from cut
With higher inflation and a resilient labour market the Fed tightened aggressively this year. The Fed Funds Rate (FFR) stands at 3.75-4.00% at the time of writing, and as we had expected for some time, Fed Chair Jerome Powell has suggested it could moderate the pace of hikes from as soon as December. We also expect the Fed to tighten more slowly – by 25bps – in February and March next year. We forecast 4.75-5.00% as the peak but contend that labour market developments, rather than inflation, are likely to be critical. If the labour market remains tight, the Fed could tighten further, while a loosening could see a lower peak.
Our expectation of a slower fall in inflation makes us cautious of how soon the Fed will reverse policy. With core inflation expected well above target and a controlled labour market loosening, we expect the Fed to keep rates on hold at 5% throughout next year, against market expectations for a cut. We expect the Fed to begin cutting rates in 2024 and forecast an end of year rate of 3.75% (markets predict 3.50%). This would fall short of the 5% cuts seen during previous recessions (other than the pandemic). However, a mild recession, where unemployment looks set to remain relatively low and inflation still high, should warrant a more cautious easing in policy.
Caution also applies to the impact of the balance sheet. The Fed is conducting quantitative tightening (QT) at a far faster pace than before, but Powell suggested a minor impact – perhaps equivalent to a 25bp FFR hike per year. While highly uncertain, we think the QT impact has been exacerbated by the parallel large build-up of reverse repo holdings on the Fed’s balance sheet. The combination has squeezed excess reserves far faster than could have been anticipated. This may unwind next year. If it doesn’t, we expect the Fed to halt QT around mid-year, earlier than expected. If it does, a fast unwind could boost excess reserves and ease financial conditions further. Either could impact the outlook for rates.
Political outlook: From midterm to long term
As we write, the final midterm election results are still unknown. As expected, Republicans look likely to regain a majority in the House but by a small margin. As we suggested the Senate was tougher and Democrats have held the majority even before the last race in Georgia is decided on 6 December.
A divided government will mean policy gridlock, with no major bills likely to pass over the next two years. This could have an additional impact on a recession because, unlike Europe, the US relies on discretionary fiscal relief, rather than automatic fiscal stabilisers, to mitigate a slowdown. A divided government risks a slower and smaller stimulus. Tensions may also arise around spending bills and the extension of the debt ceiling.
The bigger impact may be on the 2024 Presidential Election. Donald Trump has announced he will stand for re-election but Trump-backed candidates did not fare well in the midterms, weakening his standing. President Joe Biden did better than his approval ratings suggested. As inflation falls with unemployment forecast around 4% by end-2024, the economy may work in his favour. But it is not obvious to us that the President will stand for a second term, which could mean two new candidates for 2024.