Inflation is expected to slow in the coming months, but that could also mean the United States tips into a recession.
In 2022, many Americans felt pessimistic about the economy: Inflation spiked higher, fears of a recession spread, and interest rates rose.
Heading into the new year, economists say that 2023 will likely bring changes. Inflation is expected to slow as the effects of the Federal Reserve’s interest rate hikes continue to ripple through the economy. But that could also mean the United States slips into a recession and more people lose their jobs or have a difficult time finding a new one.
Since March 2022, the Fed has been aggressively raising interest rates to bring inflation under control. Making borrowing money more expensive should help cool consumer demand, resulting in slower price growth as people spend less. That could weaken the labor market and economic growth, however, since businesses could ramp down hiring or lay off workers as a result.
There is always the possibility of something unpredictable happening, but here are three different economic scenarios that could play out in 2023:
1) A mild recession could take place
Many economists are predicting that the United States will likely tip into a mild recession in 2023. That means economic growth and the labor market would weaken, but a downturn could be relatively brief and not too painful.
Beth Ann Bovino, the US chief economist at S&P Global, said she expected to see two quarters of negative GDP in the first half of 2023 and the unemployment rate to peak at 5.6 percent by the end of the year, up from its current level of 3.7 percent. But Bovino said extra savings that households accumulated during the pandemic should provide some cushion for the economy.
In the pandemic’s early days, many Americans stocked up their savings after shifting spending away from in-person events, and lawmakers passed rounds of stimulus measures to prop up the economy. Those extra savings, along with the fact that households aren’t carrying heavy debt loads, should help stave off a more serious downturn, some economists said.
Still, many Americans are drawing down those excess savings as inflation has surged and stimulus programs have expired. Much of those savings are also being held by higher-income households that might not spend that extra money during a recession since they could become more worried about their job stability and might already make enough income to cover essential costs.
Lower-income households that need the relief most have drained those excess savings at a faster clip. But checking account balances for lower-income families are still higher than they were in 2019, according to the most recent estimates from the JPMorgan Chase Institute.
“Even with US households starting to eat into their savings, there’s still a lot of savings relative to before the pandemic,” Bovino said. “Higher-income households have a lot more, but when we look at the breakdown, it’s really not extremely bad.”
Inflation is also expected to ease as the effects of the Fed’s interest rate hikes continue to spread through the economy. Inflation is already starting to slow: In November, consumer prices were up 7.1 percent from a year before and 0.1 percent from the prior month, a slowdown from earlier in 2022. Although that has provided some relief for Americans, prices for many necessities like food and rent are still much higher than they were before the pandemic.
Fed officials expect inflation to slow in 2023, although they believe it will take a few years to reach the central bank’s target of 2 percent annual inflation over time, according to the Fed’s most recent economic projections. Officials also expect the unemployment rate to rise to 4.6 percent by the end of 2023.
Kathy Bostjancic, the chief economist at Nationwide, said she expected a moderate recession to unfold around the middle of this year and inflation to slow to 2.8 percent by the end of 2023, according to the price index for Personal Consumption Expenditures. As inflation cools, however, many businesses could see slower revenue growth and shrinking profit margins as consumers pull back spending, Bostjancic said.
That could cause some employers to slow down hiring or lay off workers, meaning that even a mild recession could be painful for many people.
“Our view is that employment growth will continue to slow and eventually there will be outright job losses,” Bostjancic said. “That will have a material impact on consumer spending, and that’ll be a big part of why we fall into recession. It’s really been the labor market and the consumer that has kept the economy buoyant, but once that turns, then the overall economy will as well.”
2) The US could avoid a recession altogether
Fed officials have repeatedly said they are aiming for a “soft landing” — a scenario in which the central bank raises interest rates and the economy slows just enough to bring down inflation but averts a recession.
Soft landings are rare, though, and difficult for the Fed to pull off (the last one that took place in 1994 and 1995 is considered by some economists to be the only real soft landing). By raising rates aggressively, officials risk significantly slowing the economy and causing a big jump in unemployment. But doing too little could allow inflation to become a more permanent fixture of the economy, which could be harder to address in the future.
Fed officials say a soft landing is still possible. Fed Chair Jerome Powell said the central bank was targeting slow but positive economic growth, and a relatively weaker labor market. Powell has said the labor market continues to be “extremely tight,” with demand for workers still exceeding available supply. If those conditions rebalanced, he said, that would ease upward pressure on prices and wages.
“There are channels through which the labor market can come back into balance with relatively modest increases in unemployment,” Powell said at a press conference after the Fed raised interest rates by half a percentage point in December.
Erica Groshen, a senior economics advisor at Cornell University and a former commissioner of the Bureau of Labor Statistics, said the labor market is strong and inflation is softening, which makes her believe a soft landing or a moderate recession are the two likeliest outcomes. The unemployment rate, for instance, is near a half-century low and job growth has slowed, but employers continue to add hundreds of thousands of jobs to the economy each month. These strong conditions mean the labor market has more room to slow than normal, some economists argue.
Still, Groshen noted that soft landings have historically been difficult for the Fed to pull off.
“Maybe they will actually achieve the soft landing,” Groshen said. “But in the past, it hasn’t been easy to calibrate things that closely.”
Bostjancic at Nationwide said it was possible for the United States to avoid a contraction in GDP if “just enough froth” comes out of the labor market, wages slow, and inflation comes down quicker than economists expect.
“The chances are still rather low, but they’ve started to increase recently” as inflation has slowed more than expected, Bostjancic said.
Joe Brusuelas, the chief economist at RSM, also said his forecast included a 65 percent probability of a recession over the next year, but if inflation slows quicker than economists project and excess savings help cushion the economy, that could help the country avoid a recession. Although he said he didn’t expect the Fed to cut interest rates until 2024, he said officials could start to signal future rate cuts in the middle or end of 2023, which could boost consumer spending as households feel more optimistic about their finances.
3) A severe recession isn’t off the table
Another possible outcome is a more severe recession. Although several economists said it was unlikely, it could take place if another major supply shock or geopolitical event hit the economy.
If the global oil supply was further strained by Russia’s war against Ukraine or if China’s zero-Covid policies significantly worsened supply chain issues, for instance, that could lead to a more pronounced global economic slowdown, Bruseulas said.
“If we were to have a much more severe recession, that likely would be stimulated by another large negative supply shock emanating from the energy sector,” Brusuelas said.
A more drastic downturn could also result if inflation was more persistent than policymakers expect, Bostjancic said. That could lead the Fed to be more aggressive in its fight against inflation, meaning that officials could raise interest rates higher or keep them elevated for a longer period of time, further slowing the economy.
“It’s possible,” Bostjancic said. “Maybe inflation proves to be even more stubborn and elevated than expected.”