Slower GDP Growth and Falling Inflation in U.S. Economic Outlook for 2024

Recent Inflation Developments

The inflation fever that has gripped the U.S. economy since early 2021 appears to be breaking. Still, inflation remains above the Federal Reserve’s 2% target. In October, the 12-month percent change in the all-items consumer price index (CPI) fell to 3.2% following gains of 3.7% in August and September (the CPI inflation rate peaked at 9.1% in June 2022).The FOMC’s inflation target is based on the all-items (headline) personal consumption expenditures (PCE) price index. In September, the PCE price index was up 3.4% from a year earlier, while the core PCE price index was up 3.7%.

Many Federal Open Market Committee (FOMC) participants prefer to focus on the CPI that excludes food and energy prices, the core CPI, believing it to be a better indicator of future inflation. Here, the news isn’t as good. In October, the core CPI was up by 4% from a year earlier, a reading it has been consistently above since June 2021. However, the core CPI inflation rate also remains far below its September 2022 peak of 6.6%. The upshot is that inflation appears headed in the right direction, though perhaps not as quickly as forecasters or policymakers had initially expected.

There are several possible reasons why inflation continues to decline. First, more restrictive monetary policy tends to reduce the growth of the money supply and credit and raise interest rates, all of which tend to slow growth in the demand for goods and services. Second, if the Fed’s monetary policy is viewed as credible, then actual inflation should eventually tend to converge to the FOMC’s 2% target. Third, aggregate supply (which the Fed does not influence) and aggregate demand appear to be coming into better balance, as Fed Gov. Christopher Waller recently suggested in a speech.

Recall that while demand for goods and services began increasing sharply starting in the second half of 2020, the supply of those goods and services was constrained because of impaired global supply chains or the inability of firms to immediately boost production due to workforce shortages. When demand for goods and services increases at a faster rate than supply, the result is higher prices.

But what does it mean that aggregate supply and aggregate demand are coming into better balance? In highly simplified terms, this means that growth in the demand for goods and services—as measured by the sum of the real dollar value of expenditures by consumers, businesses, foreign entities (exports) and the government during each quarter, i.e., real gross domestic product (GDP)—is nearing the growth of the economy’s capacity to produce goods and services. The latter is often measured by real potential GDP.Real potential GDP is not measured like actual GDP. It must be estimated with an economic model, such as the one developed by the Congressional Budget Office. Real potential GDP depends on the quantity of capital and labor in the economy, as well as how efficiently those resources are used. Importantly, real potential GDP growth increases when labor productivity (output per hour worked) increases. In other words, more output (supply) can be produced with the same or fewer inputs. Higher labor productivity, all else equal, also reduces unit labor and nonlabor costs, thereby mollifying inflation.Those who remember their principles of macroeconomics will recall that an increase in labor productivity shifts the aggregate supply curve to the right; that is, more output can be produced at the same average price.

On a positive note for the supply side, labor productivity in the nonfarm business sector has increased by 2.2% over the four quarters ending with the third quarter of 2023 after falling 2.4% over the four quarters ending with the second quarter of 2022. Thus, growth of aggregate supply has increased.

Over the past four quarters, real GDP has increased by 2.9%, but private-sector forecasters anticipate some slowing going forward. Real potential GDP growth estimates can vary over the short term, and generally economists look to the longer run. One estimate of the economy’s potential growth over the longer term is the median estimate of longer-run real GDP growth (a proxy for real potential GDP growth) penciled in each quarter by FOMC participants in the Summary of Economic Projections (SEP). The latest estimate is 1.8%. Thus, demand for goods and services appears to still be growing faster than the supply of goods and services.

Key Themes in the U.S. Economic Outlook

The pace of U.S. economic activity was exceptionally strong in the third quarter, as real GDP increased at a 4.9% annual rate. Given our assumption of how fast aggregate supply should increase over the longer run (1.8%), real GDP growth will—indeed, must—slow going forward. But how fast and how far?

The table below plots the forecasts for 2023 and 2024 published in the Federal Reserve Bank of Philadelphia’s November Survey of Professional Forecasters (SPF). The table plots the annualized growth, or dollar change, in real GDP and its six major components, along with the average monthly change in nonfarm payroll employment, average monthly unemployment, and the inflation rate measured by the all-items (headline) personal consumption expenditures (PCE) price index and the core PCE price index, which excludes food and energy prices.

Real GDP is expected to increase by 2.6% in 2023, according to the SPF, sharply higher than last year’s 0.7% growth. But real GDP growth is then expected to slow to 1.3% in 2024. Private forecasters also generally project slowing growth in the major components of real GDP. For instance:

• Slowing growth of real PCE, from 2.5% in 2023 to 1.6% in 2024, is especially important because PCE is the largest component of real GDP. If real PCE growth continues to surprise to the upside, as it has for most of 2023, then real GDP growth will also likely surprise to the upside in 2024. Of course, the opposite holds as well; slower PCE growth will likely lead to slower GDP growth.
• Nonresidential (business) fixed investment is a key indicator of business sentiment, and capital spending is a key contributor to future estimates of real potential GDP. Forecasters expect real nonresidential fixed investment to slow from 3.7% in 2023 to 1.5% in 2024. Real residential fixed investment is forecast to fall by 1.4% in 2023, but then rebound in 2024 (1.9%). Housing is very interest-rate sensitive, and forecasters expect long-term nominal interest rates to decline from 4.6% in the fourth quarter of 2023 to 4% in the fourth quarter of 2024.
• Private forecasters expect the growth of government expenditures to slow to 1.8% in 2024, about half the pace expected in 2023. But concerns over rising federal debt could further temper government expenditures going forward.
• Net exports are expected to contribute positively to real GDP growth in 2023, but then contribute negatively in 2024. Net exports are sensitive to shifts in the exchange rate and the growth of the global economy. The International Monetary Fund’s latest World Economic Outlook projects slightly slower world output growth in 2024.

The expectation of below-trend real GDP growth in 2024 results in forecasts for slower—but still positive—job growth and a modest increase in the unemployment rate. Nonfarm payroll employment is projected to slow from an average of 228,417 jobs per month in 2023 to 91,000 jobs per month in 2024. The unemployment rate is forecast to slowly drift upward to an average of 4.2% in 2024, 0.5 percentage points more than its average in the third quarter of 2023.

In the September 2023 SEP, the median FOMC participant projected that headline and core PCE price index inflation would continue to decline in 2024 and eventually drop below 3%. Private forecasters concur with this outlook; headline and core inflation are forecast to fall to 2.4% in 2024.

Risks to the Economic Outlook

In late 2022 and into the second half of 2023, many forecasters projected recession in 2023 or 2024. While recession no longer appears to be the base case, that does not mean the risk of recession has disappeared. In the November SPF, private forecasters estimated a roughly 40% probability of negative real GDP growth over the first half of 2024 and a roughly 36% probability of negative real GDP growth over the second half of 2024. Those probabilities are above the approximately 15% average chance of recession historically.This is called an unconditional probability. In this case, it is calculated by taking the number of months from October 1945 to October 2023 that the economy was in recession (124) divided by the number of months it was expanding (812).

The risk of recession likely reflects many factors. The first is whether the Fed’s current monetary policy stance (i.e., the level of the real federal funds rate target range) is high enough to bring inflation back to 2% in a timely manner. In his public remarks on Nov. 9, Fed Chair Jerome Powell noted that “we are not confident that we have achieved such a stance.” Further increases in the policy rate could slow real GDP growth further in 2024.

Second, geopolitical risks abound. For instance, wars are being fought in the Middle East and Eastern Europe—both large oil-producing regions. Although crude oil prices have fallen sharply since late September, which bodes well for headline inflation, conflicts in major oil-producing areas have often resulted rising crude oil prices, and thus inflation.

Third, there are concerns about what rising interest rates in 2023 could imply for default and delinquency rates across several loan categories. Rising defaults and delinquencies could reduce profits in the bank and nonbank lending sector, raising the risk of financial instability. In this vein, the possibility of increasing defaults in the commercial real estate sector in many large cities remains a concern.

Concluding Thoughts

The U.S. economy is entering the fourth quarter of 2023 with solid momentum and a healthy labor market. In fact, the unemployment rate remains below 4%, despite the FOMC raising the target range for the policy rate from 0%-0.25% to 5.25%-5.5% since March 2022. Importantly, inflation pressures are easing. However, inflation is still above the 2% target. Senior Fed officials have signaled that continued vigilance is necessary to return inflation to the target in a timely manner.

Looking into 2024, economic conditions are expected to deteriorate modestly, though real GDP growth and the pace of job gains are expected to remain positive, and inflation is expected to decline to around 2.5%. This outcome, should it occur, would seem to vindicate those who have long believed in the possibility of a soft landing for the economy.

Notes

1. The FOMC’s inflation target is based on the all-items (headline) personal consumption expenditures (PCE) price index. In September, the PCE price index was up 3.4% from a year earlier, while the core PCE price index was up 3.7%.
2. Real potential GDP is not measured like actual GDP. It must be estimated with an economic model, such as the one developed by the Congressional Budget Office.
3. Those who remember their principles of macroeconomics will recall that an increase in labor productivity shifts the aggregate supply curve to the right; that is, more output can be produced at the same average price.
4. This is called an unconditional probability. In this case, it is calculated by taking the number of months from October 1945 to October 2023 that the economy was in recession (124) divided by the number of months it was expanding (812).