The U.S. economy is expected to experience a slowdown in growth, higher inflation, and rising interest rates in 2023, according to various forecasts and analyses. The outlook for the next year is clouded by several factors, including the debt ceiling agreement, the impact of the coronavirus pandemic, the trade tensions with China, and the monetary policy of the Federal Reserve.
The Congressional Budget Office (CBO) projects that the gross domestic product (GDP), the broadest measure of economic activity, will stop growing early in 2023 and start growing again in the second half of the year1. The CBO attributes this temporary contraction to the sharp increase in interest rates that occurred in 2021 and 2022, which dampened the demand for housing, business investment, and consumer durables1. The CBO expects that the economy will recover as inflation declines and the Fed lowers interest rates, stimulating the sectors that are sensitive to interest rate changes1.
However, the CBO also warns that its projections are subject to considerable uncertainty, especially given the possibility of a “hard landing” in China, which could have negative spillover effects on the U.S. and global economies1. A hard landing refers to a scenario where China’s economic growth slows down abruptly and significantly, due to factors such as excessive debt, financial instability, or trade disputes2. According to a simulation by the CBO, a hard landing in China could reduce U.S. GDP by about 0.8 percent in 2023 and by about 1.6 percent over the next five years2.
Inflation is another major challenge for the U.S. economy in 2023. The price index for personal consumption expenditures (PCE), which is the Fed’s preferred measure of inflation, rose by 5.7 percent in 2021 and by 5.5 percent in 2022, the highest rate in four decades1. The CBO projects that inflation will remain above the Fed’s long-term goal of 2 percent through 2024 and then fall near to that goal by 20261. The main drivers of inflation in recent years have been supply chain disruptions, labor shortages, higher energy prices, and strong consumer demand fueled by fiscal stimulus3.
The Fed’s response to inflation will be crucial for the direction of interest rates and the financial markets in 2023. The Fed has already begun to taper its monthly purchases of Treasury and mortgage-backed securities, which it had been using to support the economy during the pandemic4. The Fed has also signaled that it may start to raise its benchmark federal funds rate, which influences other short-term interest rates, as soon as March 20234. The CBO expects that the federal funds rate will rise from near zero at the end of 2022 to 1.5 percent at the end of 2023 and to 2.5 percent at the end of 20241.
The impact of higher interest rates on the economy will depend on how fast and how far they rise, as well as on how they affect consumer and business confidence. Higher interest rates tend to reduce borrowing and spending, especially for big-ticket items such as cars and houses. They also increase the cost of servicing debt for households, businesses, and governments. Higher interest rates can also have positive effects, such as encouraging saving and investment, reducing inflationary pressures, and attracting foreign capital.
The labor market is one area where the U.S. economy has shown resilience and strength in recent years. The unemployment rate fell from a peak of 14.8 percent in April 2020 to 3.6 percent in December 20211. The CBO projects that the unemployment rate will rise slightly to 5.1 percent by the end of 2023, mainly due to higher interest rates and lower output growth1. However, the CBO expects that the unemployment rate will gradually decline to 4.5 percent by the end of 20271.
The labor market also faces some challenges and uncertainties in 2023. One challenge is labor force participation, which measures the share of people who are either working or looking for work. Labor force participation declined sharply during the pandemic, from 63.4 percent in February 2020 to 61.4 percent in December 20211. The CBO projects that labor force participation will increase slightly to 61.7 percent by the end of 2023 and then remain stable until 20331. However, labor force participation is affected by various factors, such as demographics, health conditions, education levels, childcare availability, and government policies.
Another challenge is wage growth, which reflects the balance between labor supply and demand. Wage growth has been relatively strong in recent years, especially for low-wage workers, due to factors such as minimum wage increases, labor shortages, and higher inflation1. The CBO projects that average hourly earnings will grow by 4.3 percent in 2023 and by 3.8 percent in 2024, before slowing down to 2.9 percent in 2025 and 2.7 percent in 20261. However, wage growth is also influenced by productivity growth, which measures how efficiently workers produce goods and services. Productivity growth has been sluggish in the U.S. economy for the past decade, averaging only 1.2 percent per year from 2010 to 20201. The CBO expects that productivity growth will improve slightly to 1.5 percent per year from 2021 to 20331.
In summary, the U.S. economy faces a mixed and uncertain outlook for 2023. The economy is likely to experience a slowdown in growth, higher inflation, and rising interest rates in the first half of the year, followed by a recovery in the second half of the year. The economy also faces some long-term challenges, such as debt sustainability, trade competitiveness, and innovation capacity. The performance of the economy will depend on how policymakers and market participants respond to these challenges and opportunities.