Insights for What’s Ahead

• Nominal retail sales fell by 0.6 percent in November on fewer sales of durable goods and at department stores. In real terms, sales were likely more negative.
   
• The weakening in consumer spending is consistent with our narrative that the US likely started losing momentum around the end of 2022 and that a recession is likely to be more evident in Q1 2023.
   
• The Fed hiked interest rates again as expected but signaled more increases in 2023 than markets anticipated. Moreover, that no officials envision rate cuts until 2024.
   
• The Fed’s continued worries about stubborn inflation and the likelihood of some “pain” ahead is consistent with our outlook for the US economy.

Retail Sales Reaction—Consumer Spending Dips

Nominal retail sales declined by 0.6 percent in November after rising by 1.3 percent in October. Sales were particularly weak for durable goods, including motor vehicles and parts dealers (-2.3 percent), furniture (-2.6 percent), electronics and appliances (-1.5 percent), building materials and garden equipment (-2.5 percent), and sporting goods (-0.6) stores. Department store sales tumbled by 2.9 percent. Nonstore retail sales, which include online and mail order outlets, fell by 0.9 percent). Only food and beverage stores (+0.8 percent), health and personal care stores (+0.7 percent), miscellaneous store retailers (+0.5 percent), and restaurants and bars (+0.9 percent) experienced increases in sales.

On balance, the declines in purchases of durable goods is consistent with the shift in consumer desires for durables towards services, especially in-person services, now that the pandemic is in the rear-view mirror. The data are also consistent with The Conference Board holiday spending survey, where consumers stated that they were more likely to purchase nongift items like food and less likely to buy gifts this holiday season. Moreover, some of the weakness in November may have reflected spending that was accelerated into October thanks to discounts and fears about shortages.

After adjusting for inflation, which was still up 7.7 percent year-over-year by the Consumer Price Index measure, real retail sales probably were even more anemic in November. We expect real consumer spending, which includes goods and all services consumption, to slow from 1.7 percent Q/Q SAAR in Q3 2022 to 1.2 percent in Q4 2022. Overall real GDP growth is expected to ease from 2.9 percent Q/Q SAAR in Q3 2022 to just 0.7 percent in Q4 2022. Negative real GDP growth rates are still anticipated for the first through third quarters of 2023 (see US Economic Outlook).

FOMC Meeting Reaction—More Hikes to Come

Meanwhile, the Fed raised interest rates by 50 basis points to 4.35-4.50 percent at its December meeting and signaled continued hikes possibly through spring of 2023. Importantly, the Fed Chair underscored the fact the Fed desires to both subdue the level of inflation and prevent elevated inflation expectations from becoming entrenched, but that this will cause economic pain. This pain should be understood as some weakening in the labor market and possible recession, in our view.

The Federal Open Market Committee (FOMC) indicated that recent indicators point to modest growth in spending and production, which we intimate is evidence that demand is slowing according to plan. However, progress on inflation remains insufficient, with the FOMC stating that supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures are keeping inflation gauges elevated. Food and energy prices, and the influence of the war in Ukraine on both, are clearly supply-side drivers, while the spike in non-shelter services demand is a function of the pandemic largely being over in the US. We posit that broader price pressures include elevated wage inflation linked to significant labor shortages spanning nearly every industry, and stickiness in shelter costs (i.e., rents and imputed rents) reflecting past surges in home price valuations.

Against this backdrop, the Fed reduced the magnitude of interest rate hikes to 50 basis points following four 75 basis point raises, but signaled in the Summary of Economic Projections (SEP) that rate increases would last longer than markets anticipate, even if in smaller increments. Indeed, in the SEP, policymakers lowered expectations for end-2023 growth (from 1.2 percent to 0.5 percent), but raised expectations for where Personal Consumption Expenditure (PCE) inflation gauges would land at the end of 2023 (total from 2.8 to 3.2 percent; less food and energy (core) from 3.1 to 3.5 percent), and lifted the midpoint of the range for the Federal funds rate by close of 2023 from 4.6 percent (range of 4.50 to 4.75 percent) to 5.1 percent (range of 5.00 to 5.25 percent). The Fed also envisions inflation to be more stubborn than previously expected as it raised expectations for PCE headline and core inflation at the end of 2024 and 2025.

The Fed’s assessment of the US economy is largely consistent with ours. We expect real GDP growth at the end of 2023 to be -0.3 percent Q4/Q4, and for total and core inflation to be closer to 3 percent than 2 percent by end-2023 (2.8 percent year-over-year for both headline and core). Indeed, the weak GDP growth projection from the FOMC for 2023 suggests that some participants may anticipate a mild recession in 2023, which is our forecast. Our projection for the fed funds rate is for two more 25 basis point interest rate hikes, leaving the midpoint of the range at 4.9 percent (4.75-5.00) in March. The switch to more traditional 25 basis point increments is consistent with the Fed Chair’s comments that this action would be “broadly right.” However, the SEP suggests three more 25 basis point hikes that would leave the midpoint of the range at 5.1 percent (5.00-5.25) early in the second quarter of 2023 if the Fed raised rates at every meeting. Moreover, the Fed continues to signal no interest rate cuts next year, unless it raises rates beyond 5.1 percent, which is possible. Indeed, five SEP participants preferred the terminus of the fed funds rate at 5.25-5.50 in 2023, and four SEP participants preferred a terminus of 5.50-5.75 – two in 2023, one in 2024, and one in 2025. However, the Fed Chair stated that no officials projected rate cuts in 2023 and that tighter financial conditions and clear evidence that inflation was headed back down to the 2-percent target in a sustained fashion would be gauges for when policymakers would consider interest rate cuts.

Lastly, the Fed also raised its expectations for the unemployment rate but continues to anticipate limited damage to the labor market. The unemployment rate for end-2023 was lifted from 4.4 to 4.6 percent, in 2024 from 4.4 to 4.6 percent, and in 2025 from 4.3 to 4.5 percent. The upward revisions notwithstanding, these rates are very close to the CBO’s estimate of the natural unemployment rate over the next three years (4.4 percent) and just barely over the Fed’s longer-run estimate of the unemployment rate of 4.0 percent. On balance, the FOMC’s unemployment rate projections suggest continued robustness in the labor market, likely due to the continuation of labor shortages, which are a function of pandemic-related absences from the labor market, but also falling participation rates as Baby Boomers retire. The FOMC’s apparent outlook for the labor market is consistent with our own.