2023 Annual U.S. Economic Outlook

December 2022 – Economic growth appears poised to end 2022 at around 2.7 percent on an annualized basis, as measured by real gross domestic product (GDP), after rising 2.9 percent in Q3 of this year. The volatility in the GDP readings, however, has masked a key underlying trend: the continual softening of consumer spending and business investment.  Additionally, our in-house recession probability model now indicates an 83 percent chance of recession in the next few months. In the year ahead, a mild three-quarter recession is likely in the first three quarters followed by a recovery in the fourth quarter, but GDP growth is still expected to be positive for the year as a whole. Real GDP growth should expand 0.5 percent next year, primarily driven by consumer spending, as well as state and local government spending. Net exports should have less of a drag on growth, with imports falling more quickly than exports due to softer demand.

More importantly for the longer-run economic outlook, we expect consumer price inflation, as measured by the personal consumption expenditures (PCE) deflator, to fall throughout the year and average 2.6 percent in the fourth quarter of 2023. This is sharply lower than the 5.8 percent we anticipate for Q4 of this year. With the easing of inflation pressures, the Federal Reserve will likely begin normalizing monetary policy in the second half of 2023 by lowering interest rates, thus making monetary policy less restrictive.

Looking ahead to 2023, we see five key themes defining the contours of economic growth.

• Recession: We expect a recession in 2023, but not in the way you might think. The decline in economic activity is likely to be mild and short-lived.
• No stimulus: The mild nature of the downturn means that this will likely be the first downturn in recent history without fiscal or monetary stimulus.
• Supply chain challenges: Geopolitical risks remain to global supply chains, which creates greater uncertainty about the future path of inflation as firms work to diversify their supply chains, possibly at the cost of economies of scale.
• Tight labor market: We don’t expect a quick end to the tight labor market conditions that have prevailed post-pandemic. The structural factors behind the tight labor market could persist over the long term, resulting in a persistently low unemployment rate and elevated nominal wage growth.
• Inflation inflection point: One of the core factors that will likely lead us out of the downturn late next year is the inflation inflection point—a term we have coined to describe the point at which the rate of inflation falls below the rate of wage growth. This positive real wage growth, along with residual savings among consumers, should serve as the catalyst that allows for the return of robust consumer spending in H2-2023.

GDP is expected to decline by less than 2 percent at an annualized rate in each quarter of the next recession. In 2020 it shrank by an almost unfathomable 30 percent.

These days, the word “recession” ignites fear in the hearts of many Americans. The last two recessions were exceptionally challenging, inflicting immense hardship on millions of households. They were punctuated by unusual crises—a financial collapse and a global pandemic—that carved deep scars into the fabric of the economy. But these events were highly atypical, and there is no evidence to suggest that the next recession will be as damaging. If anything, the evidence points to something different altogether. The recession of 2023—if it does occur—will likely be triggered by rising interest rates. When rates go up, it becomes more expensive to borrow money, creating headwinds for sectors that rely on loans and investment capital. And rates have certainly gone up. In order to combat inflation, the Federal Reserve has raised the federal funds rate at the fastest pace in decades, leading to steeper borrowing costs on everything from mortgages to business loans.

In the past, when recessions have been induced by higher rates, they have often been shallow, brief, and confined to a small number of sectors. A similar scenario is expected in 2023. To start, the recession will likely span only three quarters, making it much shorter than the 18-month recession of 2007-2009. In addition, GDP is expected to decline by less than 2 percent at an annualized rate in each quarter of the next recession. In 2020 it shrank by an almost unfathomable 30 percent. By these two measures—depth and duration—2023 should be much milder than either 2020 or 2007-2009. It should also be less diffuse. It will likely be concentrated in manufacturing, tech and construction, and will be characterized by a substantial decline in business investment, but most other industries could be relatively unscathed. Manufacturing activity almost always declines during recessions, as global trade weakens and saving takes priority over spending. After a voracious growth phase driven by new approaches to working and living, tech firms began announcing layoffs in late 2022, and such cutbacks may escalate in 2023. Tech is heavily dependent on loans and investment capital, with prominent firms relying on outside money for everyday expenses like payroll and rent, making a tech retrenchment highly likely next year.

The construction industry is already in a deep recession, with crews breaking ground on fewer homes, apartments and office buildings than in recent quarters. Lastly, firms of all sizes are expected to scale back their investment plans. As the economy slows and corporate profits diminish, companies will probably become more risk averse, preferring to park their capital in the bond market (which now offers attractive returns—yet another result of higher interest rates) instead of buying new equipment or investing in new software.

As a result of these industry dynamics, the recession should be felt unevenly across the U.S. The West and Midwest will likely experience deeper contractions due to their heavy concentrations in tech, manufacturing and housing. The South and Northeast will also fall into recession but will fare comparatively better as they rely more heavily on tourism, international trade, government and energy. Outside of tech, construction, manufacturing and business investment, the 2023 recession is expected to be mild. Consumer spending, in particular, should perform relatively well. U.S. households have healthy balance sheets and a large amount of savings in the bank. They are still catching up on experiences they missed during the pandemic, and there is a huge amount of pent-up demand for cars. All told, spending growth should slow during the first half of 2023— but will still likely be higher than the previous year—which will be positive news for consumer-facing companies.

With a recession on the horizon next year, the focus is likely to shift to how policymakers in Washington will respond to changing economic conditions. Our assumption is that there will be no major stimulus from either the federal government or the Federal Reserve.

The midterm elections resulted in split party control of Congress, with razor thin majorities in both the House (Republicans) and Senate (Democrats). Such thin margins make major legislation difficult in both chambers and make it nearly impossible for a bill to reach the president for signature. Absent a significantly more severe recession than we are currently forecasting, we do not see enough political motivation to overcome the key sticking points between and within both parties to pass a stimulus package similar to the fiscal policy response during the 2007-2009 or 2020 recessions.

That said, there are federal programs, known as automatic stabilizers, that will stimulate certain parts of the economy when conditions deteriorate. Among these programs are unemployment insurance benefits, food assistance, tax reductions due to income declines, and increased Medicaid enrollment by individuals who experience job loss or other economic hardships. As their name implies, these programs occur automatically without the need for congressional intervention. Given the nature of the downturn that we expect, the automatic stabilizers are likely to be the only countercyclical federal programs available in the year ahead. In this regard, the 2023 recession could be markedly different than recent downturns. In 2020 and 2021, the federal government issued several trillion dollars in various stimulus packages, with a large portion going straight into the pockets of consumers. In 2008 and 2009, almost $1 trillion was deployed, sometimes in high-profile efforts like “Cash for Clunkers.” In 2023, the recession is likely to be mild, but households and businesses should not expect meaningful fiscal support.

With respect to monetary policy, in every economic cycle since the early 1980s, the Federal Reserve has responded to a rise in the unemployment rate and slower economic growth by cutting interest rates. Since the 2008 financial crisis, the Fed has also used quantitative easing—buying Treasury and mortgage-backed securities to keep interest rates low across various time horizons—in addition to cutting the federal funds rate to near zero to provide liquidity and fuel a recovery. Today’s environment, however, is very different. The Fed is actively hiking interest rates to combat inflation pressures and wants to ensure that such inflation rates do not become embedded in the psyche of U.S. consumers and businesses. Among the concerns at the Fed is the tight labor market, which is leading to wage pressures and higher consumer prices. During the downturn next year, the unemployment rate is likely to increase, easing labor market conditions in some sectors and contributing to lower overall inflation rates. However, the unemployment rate isn’t expected to reach levels that will alarm the Fed. As long as it stays below 6 percent—which would be only slightly above its long run average—the Fed will likely remain confident that it can keep rates high without causing undue hardship for U.S. households. As such, we think this will be the first downturn since the 1980s in which the Fed will keep interest rates stable. Only after the economy is clearly recovering, with strong evidence that inflation pressures have abated, will the Fed begin to cut interest rates—likely beginning in the latter half of 2023.

With the onset of a downturn likely next year, we expect imports to slide, resulting in a more modest pace of inventory building. The slowdown in domestic demand has helped to alleviate some of the supply chain pressures. Yet, long-run challenges to global supply chains are likely to remain even after the recession. Geopolitical risk factors, such as the Russian invasion of Ukraine and China’s current zero-COVID policy, have already had significant impacts on global supply chains. These impacts are expected to be long-term and present risks to our inflation and growth outlook.

China’s commitment to a zero-COVID policy has extended far longer than many would have predicted and has left business leaders with no choice other than to diversify their supply chains. This trend of businesses maintaining supply chains both within and outside of China to prevent shortages of vital products has been dubbed the “China Plus One” strategy.¹  While helpful in making sure that policy changes in a single country cannot cripple a business’s ability to acquire materials crucial to their operations, this strategy comes with the potential for higher costs. Thus, the creation of greater supply chain resilience may result in some longer-lasting inflation.

The war in Ukraine has already had a significant impact on world energy and food prices. The energy shortage is having a particularly negative impact on countries such as the U.K. and Germany. In Germany, reduced gas flow through the Nord Stream 1 pipeline from Russia could lead to a serious shortage of gas needed for heating homes during the winter. While Germany has worked hard to stockpile natural gas, a severe cold snap could result in gas rationing to the industrial sector to ensure homes stay heated. Given the country’s sizable chemical facilities, such idling of German factories, even for a short period, has the potential to create another round of global supply chain issues. Even if the war in Ukraine ends quicker than expected, there is no guarantee that the pre-invasion status quo of energy supplies from Russia will return. Thus, the risk of reduced industrial capacity in Germany has the potential to keep consumer and capital goods prices higher for longer.

Both China’s zero-COVID policy and the war in Ukraine have the potential to make inflation rates stickier than expected in 2023 and beyond. A more stubbornly high inflation rate may motivate the Fed to leave the fed funds rate high, which could result in either a deeper recession or more modest recovery.

The labor market has been historically tight over the last year, with the number of job openings far outnumbering the number of unemployed workers to the tune of two to one for a large part of the year. This imbalance between labor supply and labor demand has been a major factor in the strong run-up in nominal wages. If the expected contraction in economic growth next year occurs, it is likely that the labor market will loosen somewhat as a result. Recent announced layoffs (concentrated largely in the tech industry) are an early indication of some easing of the tight labor market. However, due to long-term demographic factors, it is likely that the looser labor market conditions will be short-lived. As the recovery takes hold late next year, we suspect that long-run challenges such as an aging population, declining labor force participation rates, the effects of long COVID and lower levels of net-migration will lead to the return of a tighter labor market. The overall impact of these trends is expected to benefit workers over the next few years, as the result will likely be higher wages. On the other hand, the tight labor market will come with challenges to businesses in the form of high labor costs and a possible decline of the overall consumer base. A further risk could be sticky inflation as higher labor costs are passed on to consumers in the form of higher prices, leading to real (inflation-adjusted) wage growth remaining flat or negative.

The largest contributing factor to the tight labor market is the aging U.S. population. Decades of increasing life expectancy² and a large decline in birth rates since the Great Recession³ have contributed to the median age of the U.S. population increasing from 30 in 1980 to 38.1 in 2019.⁴ According to Department of Commerce projections, the share of the population aged 18-64 will decline to 58.1 percent by 2030. Conversely, the share of those 65 and older will rise to 21.4 percent by 2030. The trend of a growing share of the population in retirement age and a shrinking share in pre-retirement age could ultimately lead to a mismatch in labor demand and labor supply.

The decline in the overall labor force is not the only major trend pointing toward a long-run mismatch between labor supply and labor demand. The labor force participation rate for prime working age (25-54) males has declined consistently for the past five decades, which has largely contributed to the decline in labor supply. While this trend had previously been somewhat mitigated by women entering the workforce and higher levels of immigration, the workforce participation rate of women has stagnated since the late 1990s and net-migration levels have declined significantly. One important catalyst for the decline in prime working age male labor force participation occurred in the late 1960s with the increase in unemployment, welfare and disability benefits. With this increase, the reservation wage (the lowest wage that a person will accept for a job) and the number of unemployed workers rose.

While this fact is an important part of the story, it does not explain why the U.S. has a higher share of prime working age men absent from the labor force than other industrialized countries with more generous unemployment benefits. The reason behind this disparity is hotly debated, with explanations ranging from the knock-on effects of mass incarceration⁵ to the growing share of non-college educated males choosing to sit on the sidelines of the labor market rather than work a low-paying job.⁶ While it remains unclear just how much each of these is contributing to the declining labor force participation rate for prime working age males, what is much clearer is that this trend is a major contributor to the shrinking labor supply if current public policy is left unchanged.

Another recent contributor to the lower labor force participation rate is the impact of long COVID. As of August 2022, 16.3 million Americans had long COVID, with 12.2 million of those likely in the labor force before they became ill.⁷ Using calculations and studies from the Minneapolis Fed, the U.K.’s Trades Union Congress and The Lancet, the Brookings Institution estimates that between 1.8 million and 4.1 million Americans left the labor force due to bouts with long COVID. While it is conceivable that most of these people will eventually rejoin the workforce, research on long COVID is still in its early stages and there is a great deal of uncertainty as to how long it will take them to return. Additionally, new cases of long COVID could keep these numbers elevated and further constrict the labor supply well past the slowdown expected next year. The expected persistence of a tight labor market should be good for workers, as the low supply of labor amid elevated demand strengthens bargaining power in favor of workers. With the worst of inflation expected to be in the rear-view mirror late next year, high nominal wage growth will likely translate into real (inflation-adjusted) wage gains. Strong real wage gains would likely result in increased consumer spending.

However, rising labor costs present serious challenges for businesses. As the cost of labor continues to rise, business profit margins will be compressed, which will likely cause them to cut other costs, invest more heavily in labor-saving technology, or pass those wage increases on to consumers. Automation and artificial intelligence as substitutes for labor are likely to be more attractive investments in a high-wage environment, thus, we expect these technologies to draw greater capital investment going forward. Businesses will likely be very motivated to invest in labor-saving technology to increase productivity and avoid passing costs on to consumers. A return to the pre-COVID labor market seems unlikely, even with some easing of the labor market next year. In our view, the long-run headwinds to labor force growth will continue to contribute to tight labor market conditions next year and beyond. The prevailing labor market dynamics are also likely to contribute to the mild nature of the next downturn, as firms are more likely to leave unfilled positions open or cut back hours rather than resort to mass layoffs.

Inflation was a major economic headwind in 2022, eroding consumer purchasing power and effectively giving most households a pay cut. Real personal disposable income, which is adjusted for taxes and inflation, declined at the fastest rate on record and contributed to a major deterioration in consumer confidence. Personal spending remained positive because households entered the year with lots of savings and untapped capacity on their credit cards, but with each passing month, the runway became shorter. In 2023, we expect to reach an inflation inflection point that will allow real disposable income to turn positive and lift the economy out of recession. Inflation has already begun to decelerate, and there is compelling evidence that this improvement will continue next year. To start, the global supply chain has largely healed. Supply chains were disrupted by the pandemic and the war in Ukraine, but aside from a few select cases, factories and transportation firms are operating at almost full capacity, allowing supply to meet demand, and lessening the upside price pressures.

In addition, energy prices are expected to fall. Energy, which includes a variety of categories like gas and heating oil, contributed substantially to inflation in 2022. Prices increased sharply after the war in Ukraine, which interrupted the global production of crude oil and natural gas. But in 2023, prices are expected to normalize. Energy costs almost always drop during a recession due to a slowdown in travel and industrial production, and in 2023 they will be lapping the surge of 2022. By mid-year, it is conceivable that energy inflation will turn negative on a year-over-year basis.

Food prices should also return to earth. They soared when drought and geopolitical uncertainties led to export bans, but those bans are diminishing and food production is normalizing, leading to a decline in commodity prices that will ultimately impact price tags at the grocery store and menus at restaurants. All told, these factors should converge in 2023 and move inflation closer to its long-run average. In the second half of the year, income growth is expected to outpace inflation (the inflation inflection point), allowing the consumer to spend more freely and the economy to pull out of recession.

*Includes forecast data table

Forward-Looking Statements

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Case studies, comparisons, statistics, research and recommendations are provided “AS IS” and intended for informational purposes only and should not be relied upon for operational, marketing, legal, technical, tax, financial or other advice. Visa Inc. neither makes any warranty or representation as to the completeness or accuracy of the information within this document, nor assumes any liability or responsibility that may result from reliance on such information. The Information contained herein is not intended as investment or legal advice, and readers are encouraged to seek the advice of a competent professional where such advice is required.

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