The labor market looks solid, with payroll gains exceeding consensus forecasts, few signs of stress in unemployment insurance claims, and vacancies still elevated.

Manufacturing and services sector sentiment is improving, even if the former continues to lag. Consumer confidence has also picked up. The one fly in the ointment is small business sentiment, which dropped in January and remains at concerning levels (Chart 1).

Source: Haver, abrdn, February 2024.

Credit conditions, while still tightening, are doing so across a smaller share of banks, and loan demand was less negative across many categories too.

Corporate profits rebounded over the second half of last year, and, on the whole, earnings reports have beaten analyst expectations. This could reflect less pressure on margins than we had feared, especially as wage growth eases.

Finally, NBER recession indicators show few signs of imminent distress, and the Conference Board’s leading indicator is no longer signaling a recession.

Admittedly, there are some cracks beneath this strong exterior. The latest retail sales report pointed to weak goods spending in January, while downward revisions make Q4 consumption growth look slightly less impressive than previously thought. Industrial production was also soft at the start of the year, despite improving sentiment in the sector.

Moreover, there are signs of stress in segments of the household sector, with delinquencies for auto and credit card loans increasing as financing costs reach multi-year highs (Chart 2). These dynamics look relatively contained for now, but a broadening of this trend could be the start of a larger consumer retrenchment.

Source: Haver, abrdn, February 2024.

Finally, there are still puzzling signs in the data. GDI is painting a more subdued picture of momentum compared to GDP data. It would not be a surprise to see some downward revisions to 2023 GDP growth that narrow this gap. Similarly, payroll growth looks noticeably stronger than reported in the household survey, so the risk of downward revisions to these data looks elevated as well.

These soft spots, or data irregularities, might be consistent with slower growth this year, but there are few signs of a more abrupt deterioration. To understand how likely the latter is, it is important to explore what is behind its resilience, and whether it can continue.

Demand side support from balance sheets

Balance sheet dynamics helped underpin growth last year, with consumers able to draw down an estimated $600 billion (2.4% of GDP) in excess savings to support spending. These savings piles are now smaller and likely concentrated among high-income households, making it harder to finance spending via this channel going forward.

However, improving real incomes might take some of the slack (Chart 3), with slower inflation and strong total compensation growth helping shift spending to a slower, but more sustainable trajectory.

Source: Haver, abrdn, February 2024.

At the same time, corporate margins have been insulated by the continued boost from low interest rates following the pandemic. A relatively modest refinancing profile over the past 18 months means that borrowers have not needed to lock in rates that reached levels as high as 6.6% for BBB companies. As refinancing picks up this year and next, corporates will benefit from rates that are around 100bps off this peak, lessening the potential hit to margins.

The supply side strikes back

Meanwhile, several favorable supply shocks have helped support growth. A recovery in global supply chains enabled a rebound in production and sales, particularly in the auto sector. However, this dynamic has now run its course, and disruptions in the Red Sea mean that the risks are tilted towards renewed stress.

In the labor market, stronger participation, alongside rising immigration, provided a material boost to the labor force and so potential growth in 2023. We suspect the recovery in participation is over, with the prime worker rate close to multidecade highs. But there might be scope for continued strong immigration to boost labor supply, particularly given years of low immigration during the pandemic.

At the same time, labor market matching efficiency has improved significantly, reflected in vacancies falling sharply without unemployment also increasing. However, with the Beveridge curve – which can be thought of as representing labor market matching efficiency – having largely returned to pre-pandemic norms, this tailwind may now also have run its course.

Finally, productivity growth picked up sharply, surging to 2.7% year over year at the end of last year. This is the strongest reading since the early 2000s outside of recession distortions.

Productivity growth picks up

Productivity growth could remain strong in the short term, boosted by pandemic-era R&D spending and public sector investment related to the Inflation Reduction Act and Chips Act. However, we are not convinced that this heralds the start of a multi-year acceleration in productivity growth, so much as a period of catch-up to the pre-pandemic productivity trend following a slump through 2021 and 2002 (Chart 4).

Source: Haver, abrdn, February 2024.

A more durable step change in productivity based on structural changes in the economy following the pandemic and capital deepening around artificial intelligence is possible. This is the most important source of upside risk for the US economy over the medium to long run.

Immaculate disinflation

Positive supply shocks have played an important role in cooling labor demand without layoffs, moderating nominal wage growth, pushing down labor costs for firms, and lowering inflation. All this has reduced the necessity for demand destruction to bring inflation back to target.

The results have been striking. Core PCE inflation in six-month annualized terms slowed to 1.9% over the second half of last year, at face value meeting the Fed's target.

Admittedly, there are lingering concerns over the sustainability of this decline. Falling goods prices have masked still hot core services inflation. Moreover, the January CPI and PPI data point to some reacceleration in sequential core PCE inflation in early 2024. So, it is certainly possible that the final mile of bringing inflation back to target will be bumpy.

But the big picture is that the US has made remarkable progress in lowering inflation. Moreover, the ongoing slowdown in wage growth points to further progress ahead, while inflation expectations have been well anchored over recent years.

Fed taking its foot off the brake

The moderation in inflation means the Fed is likely to begin easing policy soon. It kicked off an effective policy pivot at its October and December meetings last year, shifting from a tightening to an easing bias, and signaling deeper interest rate cuts over 2024.

The impact of this shift on financial conditions has been striking, with longer-term interest rates falling – albeit with considerable volatility – credit spreads tightening, and equities rallying.

The Fed’s own financial conditions index gives a sense of the implications of this shift for growth. In October last year, the central bank’s model suggested that changes in financial conditions over the past three years would lower GDP growth by 0.9 ppts over the subsequent 12 months. Following the easing in financial conditions over recent months, this headwind has lessened to just 0.3 ppts (Chart 5).

Source: Haver, abrdn, February 2024.

Soft landing incoming

Solid short-term growth shows that the US economy has been able to withstand the headwinds from high-interest rates. The economy may be moving past the peak of these headwinds as falling inflation allows the Fed to tolerate the recent easing in financial conditions.

We have been arguing for many months now that the runway for a soft landing has been increasing. We now think that a soft landing is more likely than not. In other words, a US recession is no longer our base case.

Not out of the danger zone yet

Despite this shift, it is important to emphasize that recession risks remain elevated compared to a typical year in the business cycle. In part, this reflects heightened uncertainty around both the supply and demand sides of the economy in the aftermath of the pandemic.

A more abrupt end to the favorable supply shock of the past 12 months may mean the economy struggles more than we anticipate. At the same time, balance sheet dynamics that have supported growth so far could evaporate more abruptly. It is also possible that the last mile of bringing inflation back to target proves more difficult, or even that the rapid decline through the second half of last year gives way to a renewed increase perhaps because demand growth is too strong or because the supply environment turns more adverse.

An increase in inflation would limit the scope for the Fed to ease policy and could even prompt rate hikes if it is severe enough. In this scenario, a renewed tightening in financial conditions could cause a hard landing.

But it is equally important to note that there are upside risks to our forecast. A continued improvement in the supply side would sustain the mix of strong growth and slower inflation over the past year. Such a scenario would probably be consistent with higher equilibrium interest rates as higher potential growth pushed up the demand for investment spending. Indeed, in this scenario, the Fed might conclude that policy was not as tight as thought and encourage it to leave rates on hold for longer and ease policy less than planned.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.

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