US Economy Defies Odds, But Markets Should Stay Wary

2024 Forecast

According to Swiss Re Institute's latest economic outlook sigma research, in early February, the US economy was growing at 2.2 percent for 2024, 1.1 percentage points higher than Swiss Re Institute's prior forecast, with headline CPI inflation expected to average 2.7 percent in 2024 after a 4.1 percent increase in 2023. With disinflation making strong progress, Swiss Re expects the Federal Reserve to kick-start a cautious easing cycle in the second quarter of this year. However, the strength of growth and upside risks to inflation render unlikely the rapid easing cycle that is being priced in futures markets.

Swiss Re expects the Federal Open Market Committee (FOMC) to begin reducing its policy rate at the May meeting, easing by 75 basis points this year, while the 10-year treasury yield picks up to 4.2 percent by year end.

Encouraging signs, but perfect disinflation is not yet a done deal.

Changing Inflation Dynamics

Swiss Re said that the faster-than-expected improvement in inflation dynamics has given the Federal Reserve greater flexibility in the case of a sudden economic slowdown. Core personal consumption expenditures (PCE) inflation, the Fed's preferred inflation gauge, slowed to below the 2 percent target on a 6-month annualized basis in the final 2 months of 2023 as disinflation made strong progress in both the goods and services components.

Headline consumer price index (CPI) inflation ticked up to 3.4 percent at the end of 2023, but the disinflationary process is poised to continue. Core CPI inflation fell from its 6.6 percent peak to end 2023 at 3.9 percent. With core goods inflation flat in recent months, the focus is on core services prices. Heading into 2024, shelter inflation was elevated at 6.2 percent, but we expect disinflation will bringing shelter down to nearly 4.5 percent by the end of the year.

Eager Markets versus Rate Cuts

The Fed pushed back against market enthusiasm at its first policy meeting of 2024 by holding rates steady and affirming the need for more disinflation progress before easing begins. However, both the FOMC statement and communications from Chairman Jerome Powell saw the bias shift from hawkish to balanced, suggesting the FOMC awaits signs that inflation will stay near 2 percent before easing policy rates, according to the Swiss Re report.

Spring Predictions

Swiss Re said, while monetary policy is the tightest it has ever been preceding recession and credit conditions remain tight, US gross domestic product (GDP) growth printed at a well-above consensus 3.3 percent in fourth quarter 2023, and geopolitical risk such as Red Sea shipping attacks will likely keep inflation risks elevated. We expect the Fed to opt for caution in March and only commence easing at its May meeting, probably at a 25-basis-points, every-other-meeting pace until fourth quarter 2024. We see the easing cycle picking up steam next year, ultimately lowering the policy rate to 3 to 3.25 percent by the end of 2025.

Labor Strength Unsustainable

The first jobs report of 2024 delivered a 353 thousand increase in payroll growth, well above expectations, while the unemployment rate remained steady at 3.7 percent. Meanwhile, initial unemployment claims remain near historic lows at just 207 thousand in early January. Job vacancies were elevated at 9 million in December, 1.8 million above their January 2020 pre-pandemic level, the report said.

The Fed is concerned by strong wage growth, up by 0.6 percent month-on-month and 4.5 percent year-over-year. Notably, the increase was distorted by a sharp drop in the average workweek, which declined to near-recessionary levels in recent months. Both signal that labor market strength is likely unsustainable. Swiss Re expects labor-market cooling to support a gradual reduction in the policy rate.

Consumers Spending Solid

Robust consumer spending and business investment were key to high fourth quarter 2023 US GDP growth. The US consumer entered 2024 on a solid footing—real personal income rose at a 3.1 percent annualized rate in December 2023, the fastest since September 2021, as inflation declined, supporting real earnings. The US savings rate remained historically low at 3.7 percent at the end of 2023 as well, implying households are confident spending amid healthy balance sheets, according to the report.

Improving consumption patterns are corroborated by a sentiment survey revival, with the University of Michigan consumer sentiment index rising to 78.8 in January—its highest level since July 2021—as inflation expectations continue to plummet. The expected inflation rate next year fell to 2.9 percent in January from 3.1 percent in December and 4.5 percent in November. Long-term expectations remained anchored at 2.8 percent, Swiss Re said.

Corporations May Need Easing

The report said that corporations still struggle to adjust to the higher rate environment. While the ISM manufacturing survey eked out a 0.7 percentage point increase in December, it remains in contraction at 47.4. The ISM services survey has declined in 3 of the past 4 months, down 2.1 percentage points in December to 50.6. Swiss Re foresees higher borrowing costs eroding corporate profit margins and slowing hiring growth, leading to economic weakening in the second half of 2024, but the onset of the Fed's easing cycle will likely forestall a deep slowdown.