By Zack Fritz, Sage Policy Group
Not only has the U.S. economy avoided recession in 2023, it has outperformed even the most optimistic expectations. Despite the effects of high interest rates on certain segments, like homebuying, employers continue to hire, consumers continue to spend, and inflation has subsided without causing a large uptick in unemployment.
As the Federal Reserve tries to navigate an elusive soft landing, risks remain, including in the form of a frozen housing market, still above-target inflation, labor shortages, and emerging signs of household financial stress.
1. The Housing Market
While most economic segments have, somewhat surprisingly, shrugged off the effects of higher interest rates, the housing market has been virtually paralyzed by the impact of extraordinarily elevated mortgage rates. This has been especially true for the existing home market which has been hampered by low inventory levels; in October 2023 existing home sales were down more than 38 percent compared to the prevailing level in 2021.
New homes, on the other hand, are selling at roughly the same rate as in the months leading up to the pandemic, largely because of the dearth of existing homes on the market. Even with the relative increase in market share for new construction, however, overall home selling activity is close to the lowest level this century.
That may be about to change. Mortgage rates have declined in each of the past six weeks, falling from the 2+ decade high of 7.79% for a 30-year fixed rate to 7.03%. That’s still extremely elevated compared to the prevailing rates of the past decade, but it’s low enough to cause some pent up demand to be released. Mortgage applications, the most real-time indicator of homebuying activity, have increased in each of the previous six weeks, indicating just how sensitive homebuying is to rate declines.
Given the dramatic disinflation observed throughout 2023, mortgage rates will continue to decline in 2024. That will undoubtedly push home selling activity higher over the course of the year. For prospective homebuyers, there will likely be a sweet spot in early 2024 when rates have fallen to a palatable level, but the buying frenzy hasn’t yet begun.
2. Rate Cuts
For much of the past twenty months, the question was “How high will the Fed raise interest rates and how long will they keep them there?” Given rapid disinflation and a slowly cooling labor market, the question has changed to “When will the Fed start cutting rates and how low will they go in 2024?”
The answer to this question varies wildly depending on who you ask. Goldman Sachs, for instance, forecasts three 25 basis point cuts in March, May, and June. Projections from the Federal Reserve are slightly more reserved, with the equivalent of three 25 basis point rate cuts projected for 2024. In either of those cases, easing of monetary policy would support, among other things, a significant increase in construction activity and homebuying.
The ultimate answer to that question, however, depends on data released between now and the Federal Reserve’s March meeting, with the most critical indicators pertaining to inflation.
Inflation has slowed dramatically over the past year and a half, with the annual rate of price increases plummeting from a catastrophic 9.1% in June 2022 to a far more manageable 3.1% in November 2023. Given that the Fed seeks to bring inflation back to a 2.0% annual rate, much of the battle has already been won.
Perhaps the greatest reason for optimism is that inflation has slowed to an absolute crawl in recent months; the Consumer Price Index increased at a 0.9% annual rate over the first two months of the fourth quarter of 2023, with prices unchanged in October and rising just 0.1% in November.
To the extent inflation remains an issue, it is almost entirely due to shelter prices, which are up 6.5 percent over the past year. Excluding shelter, economywide prices are up just 1.5 percent over the past year, and economists expect the shelter component of CPI to decline over the next several months due to methodological issues.
The outlook for inflation is increasingly benign. The Fed expects it to slow to a 2.6% annual rate in 2024. That would be a welcome development for both consumers and businesses, especially with some economic segments set to slow.
4. A Slowing Labor Market
Monthly payroll employment gains have weakened in the second half of the year, slowing from more than 300,000 per month in the first quarter of 2023 to 186,000 per month since June. This was always going to happen; the pace of job creation over much of the past few years reflected the recovery of jobs lost during the pandemic and was simply too fast to be sustainable.
Yet despite slowing, job growth is far from slow. U.S. employers have added more jobs from July through November of 2023 than over the equivalent period of each year from 2017 to 2019. Meanwhile, the unemployment rate fell to 3.7% in November, close to the lowest level in over 50 years.
Perhaps most importantly, the worker shortages that have defined the post-pandemic economy (at least for employers) are starting to improve, though there are still far too few available workers. To put this problem into context, there are currently 1.4 job openings per unemployed worker; even if the unemployment rate fell to 0.0%, there would still be a significant number of job openings.
5. Consumers Keep Spending
Despite high interest rates and a few years of elevated inflation, consumers keep spending. That’s been a surprise for many economists and forecasters, most of whom thought spending would fall off a cliff due to difficult financial conditions.
A few factors have contributed to the ongoing strength of the demand side of the economy. First, an unprecedented share of homeowners either purchased a home or refinanced in 2020 or 2021 and are, as a result, locked into low fixed rate mortgages. That has sheltered them from the impact of higher interest rates, freeing them to spend on other things.
Second, it’s difficult to know exactly how much of the excess savings—the money households stashed away due to stimulus checks, expanded unemployment benefits, and an inability to spend due to lockdowns and business closures—consumers accumulated during the early months of the pandemic remain, but the answer seems to be a lot.
Third, gas prices have plummeted due to record domestic oil production, and that has saved consumers hundreds of millions of dollars on a daily basis.
And finally, the unemployment rate remains near historical lows and wages have been rising at a faster rate than prices. If everyone who wants a job has one, and those jobs pay well, why would spending slow down?
Despite ongoing consumer momentum, minor signs of financial distress have started to emerge. Flows into credit card delinquency have sped up in recent months, and with the interest rate on credit card debt at the highest level since at least 1994, those who fall behind on payments will face particularly severe penalties.
That, along with the resumption of student loan payments in October and the cumulative effect of high interest rates and inflation, should put downward pressure on spending activity over the next several quarters. Of course, given the historical relationship between rate increases and economic activity, spending activity should have already slowed. That, to say the least, has not been the case, and early indications suggest that spending accelerated during the 2023 Holiday Season.
A majority of forecasters anticipated a recession in 2023. Despite those projections proving spectacularly wrong, the consensus outlook still puts the odds of a downturn in 2024 at roughly 50%. Some say the definition of insanity is doing the same thing over and over and expecting different results. I say that’s practice. Whether forecasters are insane or just extremely practiced at being wrong, the economy continues to outperform even the most optimistic expectations.
How long the economy can maintain that momentum is heavily dependent on when the Federal Reserve begins to lower rates; the difference between landing a plane and crashing it is all about when the pilot pulls up.