US Weekly Economic Commentary: Inflation elevated, rates headed higher

The economy entered 2023 with a spurt of activity not all of which can be attributed to unseasonably warm weather or shifting patterns of retail sales around the holiday season.

On the demand side of the economy, and with all relevant data now in hand, we estimate that in January real GDP rose 0.3% (month/month), leaving it 0.9% (at an annual rate) above the fourth-quarter average. The increase was driven by a surge in consumer spending that was only partially offset by a sizable decline in inventory investment.

Data on the supply side of the economy — the blockbuster growth of employment in January reported earlier alongside an increase in industrial production in the manufacturing sector — reinforce the conclusion that the economy began the year with newfound momentum.

What little is known hints the economy fared reasonably well in February. Both our own Purchasing Managers' Index (PMI) and that from the Institute for Supply Management (ISM) suggest activity in the service sector expanded last month. The ISM survey suggests manufacturing activity expanded as well; our PMI suggests manufacturing activity contracted, but at a slower pace than suggested by January's survey.

Initial unemployment claims remained low through February, suggesting this week's report for employment in February will be firm. Sales of light vehicles retreated from January's weather-aided level, but to a respectable 14.9 million units at an annual rate.

Revised forecast

We've revised up our projection for first-quarter GDP growth from -1.3% to -0.4%, and for the year from 0.7% to 1.0%. While the updated forecast still shows GDP contracting in the first and second quarters, the projected peak-to-trough decline is so modest (-0.1%) that it might be more accurate to characterize the episode as a pause rather than a recession.

This pause, however, will leave largely unaddressed the unsustainably tight labor market and the associated upside inflation risk. That risk is underscored in our forecast published March 6, which shows core PCE inflation for 2023 (fourth-quarter-to-fourth-quarter) revised up sharply from 3.1% to 3.9%. Underlying that upward revision are recent unfavorable readings on inflation, the drop in the US dollar since mid-October, and a downward revision in our forecast of the year-end unemployment rate, from 4.4% to 3.9%.

We see some upside risk to our GDP forecast. For example, GDPNow from the Atlanta Fed projects first-quarter growth of +2.3%, versus our -0.4% estimate, with the principal difference from our estimate being the extent to which January's surge in consumer spending is reversed in the coming months.

The Fed's dilemma

This is making the Fed's job harder, as it must contemplate pushing its policy rate above previous expectations — and above what is currently priced into markets — to prevent higher inflation from becoming entrenched.

Financial conditions were mixed last week, with the S&P 500 index rising 1.9% over the week, while the 10-year note yield rose 2 basis points, to 3.97% in late trading Friday, but it had been as high as 4.08% on Thursday. The mortgage rate has climbed to 6.65%, and the recent increase is weakening mortgage applications.

The rise in rates is partly in reaction to the recent indications of both economic momentum and persistently elevated inflation. It was also supported by hawkish communications from Fed officials. This week both Atlanta Fed President Bostic and Minneapolis Fed President Kashkari discussed the possibility of a 50-basis-point hike in the federal funds rate at the upcoming meeting of the Federal Open Market Committee. In light of these developments, we've raised our projection of the peak federal funds rate by ¼ point, to the range of 5.25% - 5.5%, with some upside risk to that forecast.

Bottom line: As the data on growth and inflation have rolled in, the risk of an imminent recession has receded, and the risk of imbedded high inflation has risen. This implies the possibility of tighter, perhaps much tighter, monetary policy, and a later but more severe downturn later this year or early in 2024. A recession averted may only be a recession delayed.

This week's economic releases:

• International trade (March 8): We estimate the nominal trade deficit on goods and services widened in January by $1.5 billion to $68.9 billion. We forecast that real net exports will be roughly neutral for GDP growth in the first quarter.
• Employment report (March 10): Indicators consistent with ongoing broad economic expansion in February — on other words, no recession yet — would include a gain in nonfarm payroll employment; an unemployment rate that remains at or near historic lows; expanded private employment; and a gain in average hourly earnings.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.