I think the Fed is slowing the economy enough to help rein in inflation without provoking a major slowdown, and I am projecting annual real GDP growth rates to remain in positive territory. Although real GDP dropped in the first half of 2022, we don’t think this marks a true recession, and we expect growth to bounce back later in 2022.
Here is the one projection that might be a surprise to you. I expect the Fed will pivot to easing monetary policy in 2023 as inflation falls back to its 2% target and the need to shore up economic growth becomes a top concern.
Interest rates. Interest rates may rise over the next 9 months, but fall after the Fed reaches it’s goal for inflation. I project a year-end 2023 federal-funds rate of 1.75%, compared with 3.25% for the consensus.
Inflation. I project price pressures to swing from inflationary to deflationary by 2023, owing greatly to the unwinding of price spikes caused by supply constraints in durables, energy, and other areas. This will make the Fed's job of curtailing inflation much easier. If this happens, the markets will celebrate with a strong move up next year, which is consistent with the long term history of the year following a midterm election.
The inflation analysis is critical to my near-term projections for GDP and interest rates. If inflation becomes much more entrenched, the Fed will have to engineer a sharp short-run recession by hiking interest rates much higher than is expected.
As long as the Fed is allowed to shift to easing in 2023, GDP should continue trending upward and then accelerate in 2024 and 2025. Housing, which is the most interest-rate-sensitive major component of the GDP, will drive much of the fluctuation in GDP growth. Lower rates in 2024 and 2025 will be needed to improve housing affordability and thereby resuscitate demand in the housing market. If you remember my analysis of the housing market last week, the pressure on real estate is eased by the lack of supply.
I Expect a More Delayed Recovery, but a More Bullish Long-Run GDP
Near-term measures of economic activity have come in weaker than expected in recent months, as marked by the 0.9% annualized drop in second-quarter GDP. Altogether since the start of the year, my near-term GDP forecasts have come down substantially owing to supply shocks (especially the war in Ukraine) and a heightened determination from the Fed to fight inflation with tighter monetary policy.
I expect GDP growth will bounce back starting in 2024 as the Fed pivots to easing. Resolution of supply constraints should facilitate an acceleration in growth without inflation becoming a concern again.
Inflation in 2022 Staying Hotter for Longer Than Expected
My inflation forecasts for 2022 has edged higher, as supply disruptions now look to be taking somewhat longer to resolve than previously expected. This should be resolved next year.
I still expect inflation to come down dramatically in 2023 and later years as supply constraints are resolved. The downward revisions to our GDP forecast also mean a more negative output gap in the near term than I expected, which will cool off inflation further.
While consensus has greatly given up on the "transitory" story for inflation, I still think most of the sources of today's high inflation will abate (and even unwind in impact) over the next few years. This includes energy, autos, and other durables.
Combining these factors with monetary policy tightening, I expect inflation to undershoot 2% in 2023 and 2024. Worries about inflation broadening out into the rest of the economy (including via high wage growth) look overblown. For this reason, I project that the Fed will need to ease monetary policy next year to get the economy back up and running. Great news for stock investors.
The Future of Interest Rates in the U.S.
Long-term forces—far outside of the control of the Fed—have acted to push down interest rates in the United States and other major economies for decades.
In other words, the natural rate of interest has shifted downward because of demographics and slower productivity growth, among other factors. These factors will keep interest rates lower for longer.
Therefore, if you can be patient with the markets now and stay invested, you will be amply rewarded in the next few years. We may see a bounce in the fourth quarter as a result of the earnings reports for the third quarter and the election. No guarantee that this will be a stronger force than the Feds interest rate push, but a probability if those earnings are a surprise on the upside.
I know it is always tough to stay the course when your investments are down, but in a secular bull market the only policy that makes sense. Stay strong and I promise you that this will all turn around and make up for lost time. The secular bull market is still in place despite the nature of Fed policy. The light is now visible at the end of the tunnel.
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