What’s ahead for the U.S. economy?

Even seasoned observers were surprised by the scale of the upheavals in the U.S. economy in 2022. From the magnitude of inflation to the aggressiveness of interest rate increases by the Federal Reserve (the Fed) to the stubbornness of global supply chain disruptions, almost everything that happened was unexpectedly severe.

In 2023, recovery may not come without the economy first enduring a recession, says Michael Gapen, Head of U.S. Economics for BofA Global Research. Here, Gapen shares insights on what to expect from a potential downturn, and where inflation, interest rates and a still-hot labor market may be headed.

This interview took place on: December 1, 2022 (updated: January 3, 2023)

What’s the likelihood of a recession in the United States in 2023? How severe would it likely be and how long might it last?

We believe a recession at this point is more likely than not. Though recessions are hard to predict with certainty, when the Fed raises rates and tightens financial conditions to control high inflation, history tells us recession is typically the result. We expect the fed funds target rate to reach 5% to 5.25% by March, which should help slow the economy, in part by cooling off the labor market.

But the recession won’t have to be severe for inflation to come down. The Fed should get some help as global supply chains continue to improve, albeit slowly, and price pressures for goods begin to ease. So we anticipate the recession will be mild by historical standards, lasting two to three quarters before resolving by the end of the year. With inflation falling and unemployment rising, we think the Fed could begin to cut its policy rate beginning in December 2023.

Is there a chance the U.S. could avoid recession? What would that require?

There could be a soft landing in which the economy slows but doesn’t qualify as a recession by traditional metrics. If supply chains recover more quickly and goods inflation falls faster than expected, the Fed won’t have to constrain the economy as much, and we might avoid the need for a major correction in the labor market. Avoiding recession is possible, but it’s not our base case.

Where do you see inflation heading in 2023? What needs to happen with jobs and unemployment in order to bring some price stability?

We expect headline and core CPI inflation to decline to about 2.8% year on year by the end of 2023. But for that to happen, a number of things will have to go right. First is geopolitical stability, meaning no major shocks to global energy or food markets. We’ll also look for some easing in prices for core goods such as new and used cars and household furnishings, which are still about 16% above pre-pandemic levels.

As for labor, we think the unemployment rate needs to rise to about 5.5% by the end of 2023 or early 2024, from about 3.7% currently. This would ease the rising cost of labor and help bring overall inflation closer to the Fed’s target rate of 2%.

How are high mortgage rates likely to affect the residential housing market outlook? 

Housing is one sector that has slowed meaningfully in response to tighter monetary policy. Having mortgage interest rates rise above 6% and 7% in 2022 made houses less affordable. Meanwhile, home prices nationally are still well above pre-pandemic levels. This has created an affordability shock on two fronts, which is bringing activity to a standstill. Housing starts and home sales have both come down rapidly.

This weakness developed in 2022 and should continue. We believe home prices will decline by 5% to 10% in 2023. That, combined with the decline in financial asset prices, could depress household spending and contribute to the anticipated recession. Economists refer to this as “the wealth effect.” We’re willing to spend more or less of our current income depending on whether the value of our financial assets and homes is up or down.

Are we likely to see a change in the relative demand for goods versus services in 2023? How could that affect inflation?

That adjustment is already well underway. As the economy reopened in 2022, spending shifted in the direction of services, and that process should continue in 2023. If consumer dollars are moving over to travel, leisure and hospitality, that opens the door for producers of goods to rebuild inventories that were depleted by supply challenges and high demand during the pandemic. Higher inventories could help bring inflation lower.

What factors might cause you to adjust your expectations regarding inflation and recession?

If the data suggest that households are willing to spend more than we anticipate, and if labor market demand stays strong, then we’ve probably been too pessimistic about when any downturn might happen. In terms of inflation, it will take a combination of a lot of good things to bring it down as quickly as we expect.

If adverse geopolitical events cause commodity prices to spike, or if China’s reopening takes longer than expected, that could prevent some goods prices from coming down. Our China team believes that China’s economy may encounter setbacks early in the year, but that it will gain momentum later in 2023 as the reopening progresses. China produces about 30% of the world’s goods, so that means supply chains should ease further. We’ll start to get evidence fairly soon on whether our assumptions are correct.