U.S. economy: Gradual cooling of the economy with elevated stress in the financial system

I am still rather pessimistic regarding the coming quarters for the U.S. economy. A recession is increasingly likely. In the fourth quarter of 2022, gross domestic product increased significantly by 2.6 percent (annualized) compared with the previous quarter. However, this growth was also due to a sharp increase in inventories. Business investment and private consumption increased only slightly. This is probably also a consequence of high inflation as well as the monetary policy tightening that began in the spring 2022. The interest rate hikes and the gradually less dynamic economy have had a particularly noticeable impact on housing investment, which has decreased significantly. In my baseline scenario, the U.S. economy will enter a recession this quarter and will start to grow again in the fourth quarter, but with little momentum. In addition to higher interest rates and lower real wages, problems in the banking sector have weighed on the U.S. economy since the collapse of Silicon Valley Bank in mid-March; lending to businesses and households is likely to decline. However, a financial crisis like the one in 2008 seems very unlikely at the moment, also thanks to the rescue measures taken by the U.S. authorities.

Before the turmoil at several U.S. banks, the Purchasing Managers’ Index for services was still in expansionary territory at 53.8 points, but for industry, at 49.3 points, it was just below the threshold of 50 above which increasing production can be expected. Consumer sentiment remained subdued, but improved a little compared with the low point in summer 2022. In contrast, there was still no sign of a turnaround in the housing slump. Against this background, consumer demand will be dampened in the coming quarters. The low unemployment rate of 3.5 percent in March is providing support, but the labor market has started to cool in a gradual way. However, many households are facing real wage losses. In addition, household savings accumulated during the pandemic are increasingly dwindling. In view of the weak momentum in private consumption and higher interest rates, high growth rates are not expected for business investment either.

Economic policy is unlikely to provide a tailwind for the U.S. economy in the current year. By summer 2023, American politicians from both parties must agree on an increase in the debt ceiling. It can be assumed that such a bipartisan compromise will include cuts to social programs, for example. The Inflation Reduction Act, which was passed in the summer of 2022 and is intended to promote investment in renewable energy sources in particular, is spread over ten years and will have only a minor impact on the economy in the individual years. Monetary policy has rapidly become less expansionary over the past year – the U.S. Federal Reserve raised its key interest rates from zero percent at the beginning of 2022 to 4.75 percent most recently. To be sure, inflation has gradually eased as energy and food prices eased in the fall and winter. But core inflation, which excludes energy and food prices, remained at 5.5 percent year-on-year in February, well above the central bank’s average two percent target. Further interest rate hikes are therefore to be expected, even if concerns about the stability of the financial system are likely to reduce the pace of interest rate steps.

All in all, the U.S. economy is likely to grow by only 0.2 percent in the current year because of two quarters with negative growth rates. In 2024, growth rates are likely to be slightly higher at 1.4 percent. Inflation will still be significantly higher in the current year at 4.3 percent, but will fall to 2.2 percent in 2024.

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