According to the first release, in Q2 GDP contracted by 0.9% annualized after the 1.6% drop in Q1, matching the definition of a technical recession. The disappointing reading was driven to a large extent by destocking, but also showed a bigger than expected impact of tighter rates on demand, especially residential investment, only in part offset by moderately rising consumption. We cut our GDP forecast for 2022 to 1.7%. Still unfavourable financial conditions and the lack of any fiscal stimulus will constrain 2023 growth to 0.7%. The GDP numbers will heighten fears of a looming recession in the US: we think that it has an almost 50% probability in H1/23.
The economy is indeed weakening but the labour marker remains strong, keeping consumption afloat despite high inflation. Lower oil prices will drive down headline inflation and are already taming expectations.
Yet, the descent towards sustainable levels remains hampered by ongoing supply disruptions. According to the San Francisco Fed, supply accounts for more than a third of the latest core PCE reading. And the weakening in home sales will take time to feed through shelter inflation; we expect core CPI inflation to end the year just below 5%.
While unanimously deciding for another 75 bps hike in July, the Fed signalled that going forward the pace of tightening could be slower if inflation does not surprise to the upside, as the slowdown of the economy will gradually restore the supply demand imbalances. Powell signalled that the rate path indicated in June, with the Fed funds rate peaking at 3.8% and reaming there throughout 2023 remains relevant. This carries two messages: first rate rises will continue, second, and more important, the market pricing of rate cuts already in 2023 is too extreme.