United States Economic Forecast has been saved
The author would like to thank Bhavna Tejwani for her contributions to this article.
Cover image by: Sofia Grace Sergi
A potential “soft landing” for the US economy might just be in sight. The end-of-year decline in retail sales and industrial production were reminders that the economy is slowing, but January saw signs that the economy might still be growing too fast for the Fed’s liking.1 Some additional obstacles have appeared on the runway, however. Deloitte’s economic forecast remains optimistic but takes into account some very significant risks for the next year.
Four key problems need to be solved for the economy to continue to grow:
Observers of the US economy need to remember that there are two separate budget problems: the need to raise the debt ceiling and the need to pass appropriation bills to fund the government. Policymakers may connect them for political reasons; one possibility is a short-term debt ceiling hike in June to allow for a negotiation over them to be tied together. But that may not happen. In any event, current political arrangements, combined with must-pass legislation, pose a significant risk to US economic activity.
Currently, however, the US economy is surprisingly healthy, given that it is coming off of a global pandemic, severe supply chain issues, and a war affecting a key global energy supplier. Labor market conditions alone provide a lot of support for the idea that the economy can achieve the desired soft landing (and, despite claims to the contrary, soft landings are not that unusual).2 Inflation remains a concern, but much less of one than it was a year ago. As long as US policymakers can avoid any damaging policy moves, like not lifting the debt ceiling, the signs are good that—after a few quarters of slow growth—the US economy will continue to innovate and create jobs, goods, and services.
Baseline (60%): Economic growth slows to a crawl in 2023, but never really declines enough to merit the label of recession. Tighter monetary policy, slow growth in Europe and China, higher energy prices, and an expensive dollar are significant headwinds for the economy. However, households continue to increase spending on pent-up demand for services such as entertainment and travel. Business investment continues to grow, particularly in information-processing equipment and software. Investment in nonresidential structures remains weak, however, as the oversupply of office buildings and retail space weighs on the market. And the housing market slump really is a recession for that sector. Inflation settles back to the 2% range by late 2023 as demand for goods slows and businesses solve their supply chain issues.
Inflation comes back (10%): The decline in inflation due to slackening supply chain pressures proves to be temporary. Continued strength in the labor market pushes wages up, leading to higher costs and prices. The Fed, having attempted to slow inflation through shock therapy in 2022, proves reluctant or unable to slow the hot labor market enough to matter, and inflation settles in at about 6%. Nominal interest rates reach levels that would have been punishing just a few years ago, but economic activity remains relatively strong.
The next recession (30%): The Fed’s focus on inflation leads it to minimize risks to the economy until it’s too late. On top of that financial shock, US authorities fail to come to a timely agreement on the debt ceiling and the 2024 budget. Although the financial shock is smaller than in 2008, the already weak economy contracts a substantial 2.7% by the end of 2023. The unemployment rate rises to over 5%, which alleviates some—but not all—of the pressure on the job market. The shock causes Congress and the President to focus on a budget solution, and the Fed to moderate policy. The economy bounces back in 2024.
The near-term outlook for consumer spending turns on two big questions:
1. What will happen when consumers finish running down their pandemic savings?
In 2020, during the height of the pandemic, we estimated that households saved about US$1.6 trillion more than we forecasted before the pandemic. Most of that money has been spent, as the savings rate has dropped from an average of around 9% before the pandemic to around 3% in the final quarter of 2022. Many households still have more cash on hand now than they normally would want, but how much of that will they spend as the economy slows? One possibility is that many consumers will remain cautious and hold on to those savings even as they are able to go out and spend. Another possibility: Spending booms for a while longer as “revenge spending” on travel and consumer services continue to grow post pandemic. The baseline Deloitte forecast assumes that continued job and income growth will support continued growth in consumer spending, but spending will slow as the savings rate eventually rises back to the 6% range.
2. As consumer services recover, what happens to durable goods?
The pandemic sparked a remarkable change in consumer spending patterns. Spending on durable consumer goods jumped US$136 billion in 2020, while spending on services fell US$473 billion over the same period. Households substituted bicycles, gym equipment, and electronics for restaurants, entertainment, and travel. Once households can again purchase services, will they begin buying fewer goods? That may be happening, as, by Q4 2022, durables spending was down 11% from the peak in Q2 2021. In Q4 2022, durable goods accounted for 12% of total consumer spending, up from 10.5% in 2019. If consumers just return to their prepandemic spending patterns, durable consumer goods sellers will be looking at a 20% fall in spending. And consumers could conceivably spend even less since the durable goods they previously bought aren’t going to wear out that quickly.
Deloitte’s forecast assumes that consumer spending grows more slowly than income over the forecast horizon as households return to previous savings patterns. Durable goods spending continues to fall over the next few years as consumer spending “renormalizes” and consumers resume spending on services.
Over the longer term, we expect the pandemic to exacerbate some existing problems. It has thrown the problem of inequality into sharp relief, straining the budgets and living situations of millions of lower-income households. These are the very people who are less likely to have health insurance—especially after layoffs—and more likely to have health conditions that complicate recovery from infection. And retirement remains a significant issue: Even before the crisis, fewer than four in 10 nonretired adults described their retirement as on track, with a quarter of nonretired adults saying they had no retirement savings.3 The stock market boom will have little impact on many people’s balance sheets, leaving many people still unable to afford retirement as they age.4
The housing sector outperformed the broader economy in the wake of the pandemic, as buyers and sellers found ways to navigate the pandemic’s restrictions. But the tables have turned. As the Fed has raised interest rates and inflation appeared, long-term interest rates have moved up dramatically. The result is a decline in housing starts from 1.7 million in Q1 2022 to 1.4 million in Q4. And house prices, which rose sharply starting in the middle of 2021, have stabilized and even started to fall in some places. Lower house prices will not be able to solve the affordability problem, however, because of the jump in mortgage rates.
Deloitte expects the fall in construction to end by the middle of this year. Housing may bounce back for a year or two after the current downturn runs its course.
Demographics, meanwhile, suggest that housing is not likely to become a key driver of economic growth in the foreseeable future. Population growth appears to have slowed to less than 0.5% per year (compared to over 1% during the 2000s housing boom). The baseline forecast assumes that, after the recovery from the current housing downturn, housing starts will eventually begin to fall. Faster medium-term growth in housing would require faster population growth, most likely from immigration. Otherwise, the heightened demand for housing during the pandemic is likely to be a short-term phenomenon.5
Businesses have ramped up investment since the initial impact of the pandemic, but they have been selective about what they are investing in.
Investment in nonresidential structures grew slightly in Q4 2022 for the first time since the pandemic, But it’s still down more than 20% from just before the pandemic and prospects in many sectors remain grim. The business case for office buildings and retail space has collapsed, with online shopping and the shift toward working at home. Current talk of converting office buildings to residential space suggests that real estate experts don’t see a lot of room for growth in office demand.
Mining structures also took a big hit because of the decline in oil prices earlier in the pandemic. As this is dominated by energy mining, it would be reasonable to expect a ramp-up in response to historically high energy prices. But that hasn’t been the case, for two reasons. First, many investors in this sector have been whipsawed in the past 10 years as prices dropped from over US$100 in 2013 to below US$50 in 2015, and then back up to over US$100 in 2021. Those investors are now less likely to react to what might be a temporary price increase. Second, the long-term prospect for fossil fuel investments looks weak, as consensus develops about fighting climate change.
The one positive development for nonresidential structures is the ramping up of government spending inherent in the Inflation Reduction Act. That act has provisions for a significant level of investment in alternative energy sources and other climate change remediation activities, which should take up some of the slack in construction capacity.
Investment in equipment has been growing at a fast rate, but a slowdown is likely. Equipment investment has been dominated by transportation equipment and information technology (IT) equipment. Remote work makes IT equipment (and software) a substitute for buildings, and so the counterpart to weak investment in commercial structures is a lot of investment in IT. That need was particularly strong as companies moved to more virtual work over the past few years. But now that the initial investments have been made, demand may dampen a bit over the next few years. Transportation equipment was pushed up by the need for delivery vehicles for virtual commerce, since eventually products have to be delivered to consumers. This may stay stronger, although it is very sensitive to the preferences of consumers for different types of shopping. If consumers prefer to return to brick-and-mortar shopping, business demand for light vehicles could weaken.
Investment in intellectual property (which consists primarily of software and R&D) accelerated during the pandemic. That’s mostly because of investment in software, and it likely reflects in the investments needed for telework. We expect this category to remain strong over the next few years as businesses continue to require software to accompany their investments in information-processing equipment.
Financing investment is becoming a bit pricier as long-term interest rates rise. However, nonfinancial businesses are sitting on a pile of cash, and interest rates are still relatively moderate. In our baseline forecast, the corporate bond rate rises to over 7% and stays there through the end of the forecast horizon. Although that may appear high, historically it is low. In fact, the cost of capital is likely to remain low enough to boost businesses’ ability to pay for all those new computers and servers, not to mention the software to run them. But even with easy financing terms, office and retail space will likely be unable to generate sufficient returns to entice businesses to increase capacity.
The Russian invasion of Ukraine has created some headwinds for US exporters. Lower demand from Europe (market for 15% of US exports) and a higher dollar because of greater global risk have created some short-term challenges.
Beyond the Ukraine crisis, things look more positive. Real US exports are now slightly above the prepandemic level. As global financial and economic conditions normalize, US exporters are expected to see more opportunities. Demand for US goods is likely to rise in the medium term as the global economy recovers from the pandemic and the Ukraine invasion shock. Further, more normal financial conditions would create more opportunities for investment outside the United States and less desire to hold dollars to avoid risk. That will potentially lower the dollar, making US exports more competitive globally.
Meanwhile, real US imports have fallen in the last two quarters. There has been a substantial decline in imports of consumer goods, reflecting the shift in consumer spending from goods to services. That is likely to continue, helping to dampen import growth.
But there is another trend that is critical to consider. Over the past few years, many analysts have begun to expect a move toward deglobalization. Global exports grew from 13% of global GDP in 1970 to 34% in 2012. But since then, the share of exports in global GDP started to fall as globalization stalled, and opponents of freer trade started to gain more political influence. All this points to the potential unraveling of the policies that fostered the earlier globalization.
COVID-19 may have accelerated this shift. Although COVID-19 is a global phenomenon, leaders made major decisions about how to fight it—in both health and economic policy—on a country-by-country basis. Examples of this are the US withdrawal from cooperation in the World Health Organization in 2020 (although the United States has since rejoined) and the unilateral decisions of both China and Russia to deploy their own vaccines before the completion of phase 3 trials. And countries with vaccine-manufacturing facilities rushed to vaccinate their own citizens rather than cooperating on a global vaccination plan. All this was in stark contrast to the joint global approach that public health professionals might have recommended.
On top of this, the US-China trade conflict continues. The White House has shown some interest in returning to a multilateral approach to trade—for example, by supporting Ngozi Okonjo-Iweala for the World Trade Organization director-general. However, US Trade Representative Katherine Tai has made a point of stating that trade policy should be aimed at helping US workers. And many of the Trump-era tariffs remain in place, with little prospect that the tariffs on China, in particular, will be withdrawn.
In addition to this, many businesses are considering rebuilding their supply chains to create more resilience in the face of unexpected events such as the pandemic and changes in US trade policy. The imperative for such changes has become stronger with the increasing supply chain issues and port delays facing importers of key components and consumer goods. It’s impossible, of course, to simply and quickly refashion supply chains to reduce foreign dependence. American companies will continue to source from China in the coming years. But companies will likely accelerate attempts to reduce their dependence on China (a process they had begun before the pandemic). Building more robust supply chains may mean moving production back to the United States, or perhaps to Mexico or some other, closer source. Or it may mean a portfolio of suppliers rather than a single source—even if the single source is the cheapest.
Reengineering supply chains will inevitably mean a rise in overall costs. Just as the “China price” held inflation in check for years, an attempt to avoid dependency on China might create inflationary pressures in the later years of our forecast horizon. And if markets won’t accept inflation, companies may to have to accept lower profits to diversify supply chains. Globalization offered a comparatively painless way to improve many people’s standard of living; deglobalization will likely involve painful costs and may limit real income growth during the recovery.
The big fiscal impulse from COVID-19–related spending has been largely reversed. The federal deficit is back to the prepandemic share of GDP (4% to 5%). This has played a role in weakening demand, especially as federal transfer payments to individuals are now closer to the prepandemic level.
The Inflation Reduction Act will likely have only a modest impact on inflation. Despite the name, the main impact of the bill will be felt years from now, not in the inflation numbers of the next few months. The bill’s main impact will likely be through the energy/climate change provisions, and those will take years to have an impact. The tax provisions, while very important to certain taxpayers, are not likely to change overall tax collections or incentives for investment that much. And many people who buy health insurance through the Affordable Care Act exchanges will be helped by the extension of subsidies for medical insurance. But the overall impact on the deficit is likely to be modest. The Congressional Budget Office scoring showed a net decrease of US$90 billion over 10 years. In the context of a federal budget with almost US$7 trillion in outlays this year, US$9 billion in one year is just not a lot of money.
The earlier infrastructure spending bill will boost government spending over the next 10 years. This spending will increase the capacity of the economy and likely help to drive some additional productivity growth. Much of this additional spending comes toward the end of our forecast horizon, however, so the short-term impact on the forecast is minor. And the total spending impulse will be moderated by higher inflation. Also, the amount of spending is relatively modest compared to the economy as a whole. According to the Congressional Budget Office, in 2026, the peak year of spending, the bill will add about US$61 billion to the federal deficit.6 That amounts to about 0.2% of projected GDP. The infrastructure bill is likely to have a positive and significant impact on public capital in the United States, but it’s not a large fiscal stimulus by any means.
Split government makes the likelihood of another significant fiscal change unlikely (although not impossible). It creates two risks. First, as agreement among the President, the Senate, and the House of Representatives becomes more difficult, the possibility of a federal government shutdown rises. A shutdown is not likely to change the overall trajectory of the US economy (unless it lasts quite a long time), but it would inject some additional uncertainty into the economy. Second, a split government brings up the possibility of breaching the debt limit. That could potentially have a significant impact on financial markets and the economy (see the sidebar, “The looming debt ceiling problem,” for an explanation of the debt ceiling and what might happen if it is not raised in time). The baseline scenario assumes that both these problems are solved in a manner that has little impact on the economy. The recession scenario explores what might happen if the debt ceiling caused a longer period of federal government nonpayment, along with a shutdown of a substantial duration.
Our baseline forecast assumes deficits will rise to US$1.7 trillion by FY27. That’s a hefty amount, one that inevitably raises the question of whether the US government can continue to borrow at such a pace. The answer is that it can—until investors lose confidence. At this point, most investors show no sign of concern about US debt. In fact, low interest rates on US government debt indicate the world wants more, not less, American debt. Risks over the five-year forecast horizon involve the ability of Congress and the President to agree to lift the debt ceiling, not any fundamental problem getting investors to buy US debt.
But the US government will face a crisis if it does not eventually find ways to reduce the deficit and consequent borrowing. The crisis may be many years away, and current conditions may argue for waiting. It would, however, be a bad idea to wait too long once those conditions lift.
The need to raise the limit on US Treasury borrowing could lead to a global financial crisis. The good news is that this is one crisis that has an easy solution. What’s the problem?
The US Treasury regularly borrows money to cover the federal deficit, but it must receive authorization from the Congress (a rise or suspension of the debt limit) to do so. In the recent past, this has become a contentious process. Indications are that it will become even more contentious. Kevin McCarthy, the Republican House speaker, has indicated that the Republican-led House wants to use the threat of not raising the debt ceiling to force the President and the Democratic-led Senate to agree to reducing the US government deficit. Would this be symbolic, or would it be intended to reverse much of the legislation of the past two years? Much depends on how weak the Republicans in Congress believe the President to be, and the willingness of the administration to accept a period of time when the debt ceiling prevents federal borrowing.
One key to understanding why the debt ceiling is likely to become a problem is that Democrats have changed their perception of their “payoff matrix”—the expected values of different strategies (compromising or not compromising) since similar battles during the Obama administration. President Biden and Senate Majority Leader Schumer demonstrated a willingness to permit the debt ceiling suspension to expire in 2021. If Republican perceptions of Democrats’ views are still shaped by their previous experience, the Republicans may misjudge how much leverage they have. This makes the possibility that the combined result of both sides’ strategies (in game theory terms) will be letting the current debt ceiling suspension lapse.
Suppose the debt ceiling suspension does lapse, and Treasury can no longer borrow above the statutory level. The US Treasury appears unlikely to agree to prioritize payments, so bills would be paid randomly depending on that day’s cash flow. There would almost certainly be days when the Treasury would have to miss interest payments on Treasury securities. Some analysts have described this as “default,” although it’s very different from a true default or insolvency. But it’s not just interest payments. Treasury is likely to miss payroll payments for federal workers and social security payments for retirees, depending (noted) on a particular period’s cash flow.
The initial outcome of missing a Treasury payment might be relatively muted. At first, prices of specific Treasuries (those scheduled to pay interest on a date when Treasury would not be expected to have cash) would rise. But a longer period of time when Treasury payments become uncertain might create difficulties for the global financial system, which depends on Treasury securities as its foundation. Nowhere else can financial market players find such a large supply of low-risk assets, so Treasuries will not be easily replaced.
The good news is that, over time, the political pressure to solve the problem will grow. Missed social security checks should get the attention of enough members of Congress to allow a bipartisan fix. And Wall Street will certainly be pressuring those members of Congress who are business-friendly to avoid creating the conditions for a global financial meltdown. The United States has no fundamental inability to make debt payments, unlike Argentina or Greece. It’s just a matter of passing the law to allow the Treasury to do so.
The conversation on labor markets has switched—and fast. Not long ago, employment was millions below the prepandemic level, and the main question was how difficult it would be to get all those workers back on the job. Now, employment is above the prepandemic level and business commentary is full of talk about labor shortages and stories about employers struggling to find workers. It’s hard to argue that the economy is experiencing a recession when the unemployment rate remains low, job growth is strong, and the ratio of job openings to unemployed people remains far above normal levels. The labor market has remained surprisingly strong, even as indicators of demand and production turned weak in late 2022.
While employment has fully recovered from the pandemic, labor force participation has not. The January 2023 labor force participation rate was 1.2 percentage points below the rate in February 2020. That amounts to over 3 million people who are missing from the labor market. Who are those people? They are mostly older Americans. The labor force participation rate for ages 16–64 has been around the prepandemic level since early 2022. But the rate for people over 65 has fallen quite a bit. Many of these people have probably retired, in the sense of expecting to remain permanently out of the labor force, but some can likely be enticed back with the right compensation packages and flexible working hours and conditions.
As is the case in many areas, the pandemic accelerated trends that were evident even before it started. Slow labor force growth and continued high demand had already created conditions that required companies to offer higher wages to lower-skilled workers and to be more imaginative about hiring. In the post–COVID-19 world, companies that make extra effort to find the workers they need and provide conditions to attract those workers will have an important competitive advantage.
Deloitte’s baseline forecast assumes that job growth slows to sustainable levels (less than 100,000 jobs per month) in the next few years. It’s important to remember that job growth is likely to slow simply because the workers aren’t there. That means that slowing growth—if the unemployment rate remains low—is not necessarily a signal of an economic downturn. In the forecast, the unemployment rate rises a bit as growth slows in 2023, but the job market remains relatively tight. Over the longer horizon, labor force growth slows to just 0.2% per year, presenting continuing challenges for employers. It’s a demographic fact that employers will have to learn to live with.
For over a decade before the pandemic, interest rates were unusually low. An inflation rate of around 2% suggests a neutral Fed funds rate of around 4%, but the funds rate remained close to zero for 10 years after the global financial crisis. The pandemic seems to have jolted the financial system in a manner that requires higher interest rates—and the Fed is willing to oblige. Raising the Fed funds rate by over 4 percentage points in one year suggests the degree of urgency Fed officials feel.
Although it seems extreme, the current policy is nowhere near as tight as the anti-inflation actions the Fed undertook over 1979–1982. At that time, the nominal rate went over 19%, and the real Fed funds rate hit almost 10% in one month. Despite the recent dramatic hikes, it would be a mistake to overestimate the potential impact of the higher Fed funds rate.
That’s cause for some optimism, but it doesn’t mean that interest rate hikes can’t cause pain. Long-term rates are rising, again to levels that would have been considered normal in the past. But if the corporate bond rate goes above 7%, as implied by our baseline forecast, holders of past corporate bonds issued at the low rates of the past 10 years will have to eventually take a loss. Exactly how the loss is recorded depends on the accounting and regulatory environment of the investor. Could this create systemic problems for the financial system? So far, it looks like investing organizations have managed to prevent any significant impact from the repricing of low-return bonds. The success of US bank stress tests is an additional sign that the financial system is in good shape. But this remains an important potential problem for individual investors, and for the financial system.
In the medium term, the key question is whether long-term interest rates will once again settle in at a relatively low level, or whether they will return to levels consistent with the experience before the global financial crisis. Those arguing that interest rates will return to low levels point to fundamentals such as demographics (the aging global population).7 Those arguing that interest rates will return to previous behavior point to the slowing of savings growth from China and the need for large investments (whether public or private) to reduce the impact of climate change.8 The Deloitte forecast assumes that long-term interest rates remain relatively high, as demand for capital remains strong while global savings grows more slowly over the coming years.
Our baseline forecast assumes that the Fed will raise rates twice more in early 2023 before stopping and holding the funds rate at 5.25 percent. A Fed funds rate of 5% implies a significantly higher long-term rate if demand for capital remains strong. Our baseline forecast has the 10-year Treasury note yield rising to 6.3% in the later years of our forecast. This is consistent with the historical relationship of these rates under moderate inflation: Should inflation continue to be high, the spread between the 10-year note and the Fed funds rate could continue to rise (as investors account for expected inflation in the later years of the note’s period). Investors should take care to watch for the possibility of higher interest rates—although by the standards of the 1970s and 1980s, these rates are still quite low.
Of course, interest rates are always the least certain part of any forecast: Any significant news could—and will—alter interest rates significantly.
As of this forecast, inflation has been tamed for over six months. However, is it too soon to declare victory? The Fed may think so, but it is becoming a bit harder to support the idea that inflation has become embedded in the economy. That’s especially the case since a significant portion of the current inflation is in the shelter component. This component typically lags contract house prices and rents,9 and is now reflecting last year’s runup in housing prices. Contract prices are now falling, suggesting that the shelter component of the consumer price index (CPI) will, in a relatively short time, become a drag on CPI growth rather than a source of growth.
The Deloitte forecast continues to assume that the current inflation is “transitory” in the sense that it will dissipate over time. Companies are already finding ways around many of their supply chain problems, as evidenced by falling transportation prices and growing inventories. And our forecast of declining demand for consumer durables suggests that the need for expanded production will gradually decline, preventing any further outbreaks of supply chain issues. Our baseline forecast shows CPI inflation falling to below 3% by 2024. We remain optimistic that today’s households and businesses will avoid the unpleasant experiences of the long inflation and painful disinflation that their predecessors experienced during 1970–1985.
Unless otherwise indicated, all economic data comes from the US government or, where indicated, private sources have been sourced from Haver Analytics.View in Article
Alan S. Blinder, “Landings, soft and hard: The Federal Reserve, 1965–2022,” Journal of Economic Perspectives 37, no. 1 (2023): pp. 101–120.View in Article
Board of Governors of the Federal Reserve System, Economic well-being of US households in 2021, May 2022.View in Article
Ibid.View in Article
Lester Gunnion, Why is the housing sector booming during COVID-19?: Economics spotlight, November 2020, Deloitte Insights, November 20, 2020.View in Article
Congressional Budget Office, “Senate Amendment 2137 to H.R. 3868, the Infrastructure and Jobs Act, as proposed on August 1, 2021,” August 9, 2021.View in Article
Olivier Blanchard, “Secular stagnation is not over,” Peterson Institute for International Economics, January 23, 2023.View in Article
Kristin Forbes et al., “Economic shocks, crises and their consequences,” panel session at the American Economics Association 2023 Annual Meeting, January 7, 2023.View in Article
Xiaoqing Zhou and Jim Dolmas, “Surging house prices expected to propel rent increases, push up inflation,” Federal Reserve Bank of Dallas, August 24, 2021.View in Article
The author would like to thank Bhavna Tejwani for her contributions to this article.
Cover image by: Sofia Grace Sergi