U.S. economic growth slowed considerably in 2022 as the underlying environment faced new challenges.
The Federal Reserve continues to pump the brakes on the economy by raising interest rates in an effort to slow the economy without triggering a recession.
So far this year, the economy continues to exhibit relatively stable – albeit slower – growth, led by a strong job market.
Through much of 2022, investors braced for the potential onset of a recession in response to focused efforts by the Federal Reserve (Fed) to slow economic growth and curb inflation. While the economy slowed significantly, a recession has, to this point, been avoided.
As measured by Gross Domestic Product (GDP) growth, the economy in 2021 grew at an annualized rate of 5.9%, the fastest rate of growth in a calendar year since 1984. The economy slowed significantly in 2022, with GDP increasing at an average rate of just 2.1%.1 After being in negative territory in the first two quarters of 2022 (down 1.6% in the first quarter and 0.6% in the second quarter), the economy bounced back modestly in the second half of the year (up 3.2% in the third quarter and 2.7% in the fourth quarter, all figures on an annualized basis). Consumer spending and corporate profit growth proved resilient in a more challenging environment.
Nevertheless, there are questions about the direction of the economy going forward. “The economy, at this point, could tip in either direction with regard to whether we see a recession in 2023,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “There’s good news in the most recent reports in that consumer spending is holding up and inflation is coming down. But sales of durable goods are slowing and there may be other challenges ahead.” U.S. Bank’s economic forecast for the year shows the U.S. economy narrowly avoiding recession.
If, however, the economy does slide into a recession in 2023, expectations are that it won’t be severe. “Our view is that we’re less concerned with how deep a potential recession is,” says Eric Freedman, chief investment officer at U.S. Bank. “Our bigger concern, if it does occur, is how long it lasts. It’s possible that we see a relatively stagnant economy in the U.S. and Europe in 2023.”
One contrary indication of an imminent recession is the job market, which continues to feature a very low unemployment rate (3.4% in January) and solid job growth. In addition, there are significantly more job openings than there are available workers.2
How should investors assess the state of the economy today and what should they expect from here?
Beginning in early 2021 and continuing through 2022, the re-emergence of inflation became the biggest economic story. The inflation rate, as measured by the Consumer Price Index, peaked in June 2022 at more than 9% over the previous 12-month period.3 This was the highest level in more than four decades and exceeds by a wide margin the inflation target established by the Fed as it sets its monetary policy. In the closing months of 2022, the inflation rate slowed, and as of January 2023, stood at 6.4% over the previous 12-month period. The Fed targets an inflation rate that averages close to 2% over time.
“The Fed has made clear its first target is to soften inflation.”
Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management
In response, the Fed made a dramatic pivot in its strategy. In March 2022, it raised the primary interest rate it controls, the fed funds rate, for the first time since 2018. In December 2022, the Fed set the target fed funds rate to 4.50%-4.75%, up from near zero percent before the March rate hike. The Fed also ended its bond buying program and began reducing its bond holdings. They designed this strategy to push interest rates higher in the broader bond market, raising borrowing costs to temper the pace of economic growth. “The Fed has made clear its first target is to soften inflation,” says Haworth. He believes the Fed’s 2% inflation target may not be reachable before 2024.
While investors and consumers are more attentive to inflation’s spike, other factors added uncertainty to global economic environment. Perhaps none is more significant than the Russia-Ukraine war. Russia is a major energy supplier, particularly for much of Europe. Both Russia and Ukraine are notable agricultural exporters. Oil and natural gas prices became more volatile since the start of the war in February 2022, and agricultural prices also temporarily spiked in mid-year. Prices for most commodities retreated since that time.
Higher interest rates had their greatest effect on areas of the economy that interest rates most directly affect. For example, housing activity has been in decline due to a significant rise in mortgage rates. In addition, the government’s 4th quarter 2022 economic summary showed a dramatic decline in new residential construction activity. “Housing demand softened with higher mortgage rates,” notes Haworth, “yet underlying fundamentals of consumer finances and the housing market both remain favorable, even as higher mortgage rates affect home affordability.”
Despite the Fed’s monetary tightening actions since March 2022, job growth exceeded projections, averaging more than 375,000 per month for all of 2022. “While payroll growth remains strong, it slowed in the second half of the year,” says Haworth. “Still, it’s not slowing that quickly. What the Fed is most focused on is wage growth and its impact on the overall inflation rate.” Average hourly earnings rose modestly in 2022 but did not keep pace with the elevated inflation rate.
A key question is whether the Fed’s aggressive posture allows it to successfully tackle the inflation threat while steering the economy toward a “soft landing” and avoiding a recession.
“It seems likely the economy may stay out of a recession, but we expect that real GDP growth will be relatively flat in the near term,” says Matt Schoeppner, senior economist at U.S. Bank. “It might qualify as what we call a ‘growth recession,’ where we see a slow economy, but with few ramifications for the job market.” Schoeppner says to this point, the economy has demonstrated surprising strength despite the Fed’s efforts to temper growth. “Growth in consumer spending was relatively steady throughout 2022 and into early 2023,” says Schoeppner. “We’re seeing some signs of slight weakening in consumer activity, but not the significant deterioration that some feared.”
One key factor to watch will be the delayed impact of Fed rate hikes. It’s estimated that there is a potential 12-month lag between when the Fed raises short-term interest rates and when those changes are felt in the economy. “We may see the impact occur in different ways,” suggests Haworth. “Consumers dealing with higher interest rates may be most directly affected.” Individuals may be less likely to pursue major purchases that require financing, such as homes and cars. “On the other hand, businesses may not be as directly affected,” says Haworth. “Many firms issued bonds with 3-5 years of maturity prior to rates going up, so they may be in a position to ride out the current rate environment without seeking further, more costly financing.”
Both stock and bond markets experienced negative returns in 2022. As the Fed laid out its planned policy shift early in 2022 (raising interest rates and ending its sizable bond market investments), investors became more cautious. “When the Fed says they’re going to raise rates, generally other asset classes will reprice lower in response,” says Freedman.
Interest rates across the board in the bond market moved up rapidly in 2022. Higher rates may continue to put pressure on equity markets. “If investors can earn higher interest rates now than they did prior to the Fed’s policy shift, it makes stocks less attractive,” says Haworth. “Investors are less willing to bid up stock prices in that kind of environment.” The result, says Haworth, is more volatility for stocks that may persist for some time.
Haworth notes that expectations for corporate earnings are in retreat relative to previous projections, reflecting the impact of potentially slower economic activity and higher borrowing costs for companies. He notes that earnings are the primary focus for stock investors now, with issues like Fed rate hikes and ongoing inflation a lesser concern. The subdued earnings outlook is one reason for a cautious, near-term outlook for stocks. In addition, Haworth says the job market may be a bellwether for the direction of the economy from here. “If that starts to weaken, it may mean the economy is about to face more headwinds.”
Consider reviewing your current portfolio with your wealth management professional to determine if it’s consistent with your long-term goals and positioned to meet the challenges of what continues to be an uncertain market and economic environment.
Have questions about the economy, the markets and your finances? Your U.S. Bank Wealth Management team is here to help.
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