After two straight quarters of year-over-year decline, the third quarter’s 2.6% annualized growth in gross domestic product was a solid improvement and much better than expected. The third quarter’s results clearly dispelled the notion that the U.S. economy is in a recession, and the silver lining was the ongoing resiliency in consumption. Even though consumers made fewer purchases, they continued to spend on both goods and services and helped lift GDP. A strong labor market, rising wages and access to excess savings built up during the pandemic have given households strong balance sheets that have helped spending continue despite inflation and higher interest rates.
Nonetheless, the economy is cooling and interest-sensitive sectors, in particular, have seen a significant pullback in spending. This has been especially notable in housing, where the Federal Reserve's aggressive efforts to rein in inflation have resulted in a sharp rise in mortgage rates that have left many potential buyers unable to afford a home. Correspondingly, builder confidence in the market for newly built single-family homes posted its 11th straight monthly decline in November and builders are cutting back on single-family construction.
GDP is expected to grow very gradually in the closing months of 2022, at best about half of what was recorded in the third quarter. Consumers are stepping back to a degree and changing how they allocate their resources, spending more on food and less on other retail goods. At the same time, spending on services has been hearty in recent months and there is no reason to expect that it will moderate even with the continued upward pace of service sector inflation.
Even with inflation, the willingness to spend has been stable for the better part of this year, with retail sales growing 7.5% year over year for the first 10 months. That’s on track with NRF’s forecasts that overall, 2022 retail sales and November-December holiday sales will both grow between 6% and 8% over 2021. The pace slowed to 6.5% in October, but that was largely due to the comparison against strong early holiday shopping in 2021.
Many eyes have focused on October’s inflation data, and a range of measures were better than expected. The big questions are whether inflation has peaked, and will it be coming down? The Consumer Price Index was up 7.7% year over year, down from 8.2% in September for the lowest inflation level since January. At the same time, core inflation (which excludes food and energy) was at 6.3%, down from September’s 40-year high of 6.6%. Meanwhile, average hourly earnings for October were up 4.7% year over year compared with 5% in September, also sending a message that inflation may be receding. While these changes were all in the right direction, it is too soon to see if they are the beginning of a stable downward trend.
Overall job growth has clearly slowed since the start of the year, but labor demand isn't cooling as quickly as the Fed – and markets – would like. Additions are moderating but job openings bounced back in September to 10.7 million from 10.3 million in August. The labor market eased somewhat in October as payrolls increased by 261,000.
It is hard to anticipate whether the Fed’s monetary tightening will lead to a recession or how bad one might be if it does occur. The risk is clearly elevated by the current framework of rate hikes, but the full effects remain to be seen and one key is how much slowing in the labor market is needed to bring wage growth in line with the Fed’s long-run inflation goals.
As the labor market slows further, as expected in 2023, income growth should slow with it. The good news is that slower job gains should sap momentum from both consumer spending and rising labor costs, hopefully reducing inflationary pressure.
Even though both may slow, employment will still be growing, and consumer spending should remain positive. There will be economic hardships, and some may feel like they’re in a recession. But for those who have jobs and feel secure about their employment, careful spending will continue. The downside risk is that “sticky” wages and prices for services – both tend to stay up once they go up – will keep inflation aloft and push the Fed to hold rates higher for longer.
So, what does this all mean? The slowdown in economic growth in 2022 combined with the expansion in the labor market have clearly helped bring economic activity in better balance with labor. But there is a long journey ahead between where we are now and where we need to be. If inflation pressures continue to lessen, the Fed may not be inclined to persist with aggressive interest rate hikes, but that remains to be seen. In the meantime, if prices for gas, groceries and other products decelerate, we will all be able to breathe a little easier.