This Week’s Developments in the US Economy

Pause, Pivot, and the Outlook

In last week's update, we discussed potential paths for Fed policy and the implications for the economic outlook. The surprise policy pivot signaled by the Fed this week marks a meaningful shift, particularly the quarterly Summary of Economic Projections (SEP), which highlighted greater optimism for achieving a soft landing in the coming year.

While we anticipate some moderation of growth is ahead in the near term, the Fed’s signaling of potential interest rate cuts has positive implications for demand-driven sectors in our view. Demand-driven sectors—which have momentum entering the new year—may see more potential for growth and stability. We believe consumer activity and household formation may see more upside in the coming year, which improves our outlook for 2024.

The Last Mile to 2% May Be Long, but It May Not Matter

Over the course of the year, we focused on sticky inflation components as it became clear that these sectors could prop up year-over-year core inflation readings. The recognition of these components and their resistance to interest rate changes appears to be incorporated into the Fed’s projections for the coming year as well as the projected policy path, which appears to be agnostic of fully achieving a two percent target before cutting rates.

In the Fed’s outlook for 2024, the projection for year-end inflation is 2.4% for both headline and core PCE. When considering how PCE inflation dropped over 400 basis points from its peak of 7.1% in less than 18 months, the projected 40 basis point drop over the course of the next twelve months is meaningfully slower—and likely a function of sticky components.

Interest rate-sensitive items have already fallen and contributed to the progress made on inflation, and what largely remains are the items less affected by interest rates, such as contractual and lagging items. For example, 290 basis points of the current 3.0% headline PCE is derived from services categories, and the vast majority of those services consisted of “Household Consumption Expenditures,” of which approximately two-thirds come from financial services and insurance, housing and utilities, and health care. These are typically contractual in natural or are measured on a lagged basis up to one year. A contract example: insurance and medical costs are based on contracts that have been agreed on in advance and are thus not dependent on interest rates. A lagging example is housing: with the National Association of Realtors reporting the median sales price of existing homes to have increased in October by 3.4% year-over-year, this measure will continue to influence a portion of the housing component for another year.

What We’re Watching

Our high conviction themes for 2023 included (1) the strength of the labor market and (2) the strength of the US consumer. Both are meaningful contributors to economic growth—in particular demand-driven sectors—and both have demonstrated extraordinary resilience throughout the year. While we have observed some softening in recent months, we anticipate continued momentum in both areas entering 2024.

To put a finer point on the resilience observed over the past year, both the labor market and GDP growth outperformed the Fed’s expectations going into 2023. The most recent monthly employment data highlight this resilience as the unemployment rate dropped to 3.7% from 3.9% the month prior, the labor force participation rate (“LFPR”) ticked up to 62.8%, and nonfarm payrolls increased by 199K. Similarly, annualized GDP growth has outpaced the Fed’s projections from earlier in the year (see accompanying visual).

While we anticipate moderation for both areas in the near term, we view this week’s positioning from the Fed as having meaningfully positive implications for the coming year.