Notes on the Economy – Q3 2023 Summary

TOO GOOD TO LAST 

The advance estimate for U.S. real GDP growth in the second quarter of 2023 was an annualized 2.4%. This was the fourth in a string of quarterly growth figures of 2.0%, or more. The strong third-quarter growth is all the more notable as it occurred in spite of a substantial slowdown in consumer spending along with outright declines in residential investment and net exports. Private spending for capital investments was the surprise positive for the quarter. Encouraged by federal subsidies and tax credits allowable under recent legislation, it advanced an unusually robust 7.7%.  

Although inflation is trending downward, it is still too high for policymakers and for the proverbial man on the street, as well. The Federal Reserve (Fed) has now increased the federal funds rate target a cumulative 525 basis points. Even so, inflation is still above the Fed’s 2.0% objective, and employment conditions are very worker friendly. The unemployment rate, for instance, is at a 54-year low of 3.5%, a level inconsistent with the Fed’s inflation target. 

As it turns out, the U.S. economy’s first-half performance in 2023 was among the best relative to major developed economies. Global economic activity has largely rebounded from the COVID-19 pandemic. However, as in the United States, it remains handicapped by persistently high inflation, which has suppressed the purchasing power of households and businesses, and by tighter monetary policies, which have increased financing costs and reduced the supply of credit. Unsurprisingly, this has reduced the growth of economic output in most developed economies.  

HEADLINES – WHAT’S IMPORTANT 

1. The Inflation Battle Is Not Over – 12-month core CPI inflation (i.e., inflation in the Consumer Price Index minus food and energy) has trended downward since mid-2022 but was still at 4.7% in July. Fed policymakers are shooting for 2.0% on a sustainable basis. 
2. Interest Rates Have Not Yet Peaked – It is a good bet that the Fed’s policy range for the federal funds rate will be subject to at least one more 25-basis-point increase before year end. 
3. Bond Portfolios Should Be Approaching Maximum Policy Durations – Longer-term bond yields tend to peak within four months of a peak in the federal funds rate. 
4. The Rally in the S&P 500 Is on Borrowed Time – Profits will struggle for growth; monetary policy will be a persistent headwind; contraction risk is real. 

 LOOKING AHEAD 

The economy appears poised for strong real GDP growth in the third quarter. Still, that strength is likely to fade, and growth will probably weaken substantially going into 2024. July’s retail sales report showed sales were up 0.7% (not annualized). Products covered in the survey experienced little inflation, implying that real sales were up more than 8.0% on an annualized basis and suggesting that consumer spending will have a strong third quarter. Similarly, the latest housing starts and new home sales data point to a surge in third-quarter residential investment. 

In any event, the Fed will likely maintain a monetary policy restrictive enough to restrain such surges in economic activity and slow growth of total output. That is because inflation remains well above the Fed’s target, and because strong economic growth has boosted the demand for labor, pushing the unemployment rate down to a level incompatible with that target. More likely, Fed policymakers will raise its target range for federal funds an additional 25 to 50 basis before holding it steady for an extended period.  

Developed economies have played the major role in a slowdown of global growth in the first half of 2023. Globally, central banks, especially in developed economies, have tightened monetary policies and restricted economic growth in order to reduce the persistently high inflation that has followed in the aftermath of the COVID-19 pandemic. In July, the International Monetary Fund (IMF) published 2022 aggregate economic growth estimates of 3.5% for the global economy, 2.7% for developed economies, and 4.0% for emerging and developing economies. The IMF’s projected 2023 growth for those regions is 3.0%, 1.5%, and 4.0%, respectively. The slow improvement in the inflation picture will likely lead many monetary authorities to maintain interest rates at high levels for some time. 

* The information contained within this edition of the Notes on the Economy Executive Summary is based on data released as of Aug. 18, 2023. 

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