Washington, DC:
Resilient Demand and a Robust Labor Market
The U.S. economy has proven resilient in the face of the significant
tightening of both fiscal and monetary policy that took place in 2022.
Consumer demand has held up particularly well, boosted initially by a
drawdown of pent-up savings and, more recently, by solid growth in real
disposable incomes. Prime age labor force participation has risen above its
pre-pandemic peak, the unemployment rate for women and African Americans
has fallen to historical lows, and real wages have been rising faster than
inflation since mid-2022. Growth of around 1.2 percent (on a q4/q4 basis)
is expected for this year, modestly picking up momentum later in 2024. This
slowing, but still-solid, growth is expected to be associated with
unemployment rising slowly to close to 4½ percent by the end of 2024.
Rising wages for lower income workers, rapid employment growth, and
pandemic-related government transfers made important inroads into reducing
poverty in 2021. Most notably, the share of the population living in
poverty fell markedly from 11.8 percent in 2019 to 7.8 percent in 2021 and
the poverty rate for black and Hispanic households fell by almost twice as
much as the national average. Close to half of this improvement came from
fewer children living in poverty (mostly due to the economic impact
payments and the fully refundable child tax credit). Unfortunately, these
impressive gains in tackling poverty appear to have been largely unwound in
2022 as pandemic benefits expired and real wage growth for lower income
workers moderated.
A Persistent Inflation Problem
The strength in demand and in labor market outcomes is a double-edged
sword, contributing to more persistent inflation. Goods inflation has
leveled out and shelter price growth is expected to start moderating in the
coming months. However, past nominal wage increases are now feeding into
non-shelter services. While core and headline PCE inflation are expected to
continue falling during 2023, they will remain materially above the Fed’s 2
percent target throughout 2023 and 2024.
Achieving a sustained disinflation will necessitate a loosening of labor
market conditions that, so far, has not been evident in the data. To bring
inflation firmly back to target will require an extended period of tight
monetary policy, with the federal funds rate remaining at 5¼–5½ percent
until late in 2024. Model estimates suggest such a path would be sufficient
to slow demand, restore balance to the labor market, and lower wage and
price inflation. However, insofar as models are calibrated on past
experiences, they offer only an imperfect guide to the current conjuncture.
Given the important uncertainties facing the U.S. economy, it will be
essential for the Federal Reserve to communicate carefully how it assesses
the incoming data and to provide clear guidance on what this means for its
expected path of the policy rate. In this regard, greater emphasis should
be placed on the need for interest rates to remain at high levels for an
extended period of time. This may help align financial conditions more
closely with the intended path for policy. Communications should continue
to underscore, though, that the FOMC’s forward guidance is not set in stone
and actual policy outcomes will depend critically on incoming data.
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United States: Selected Economic
Indicators
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2022
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2023
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2024
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Real GDP (annual growth, percent)
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2.1
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1.7
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1.0
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Real GDP (Q4/Q4, percent)
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0.9
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1.2
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1.1
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Headline PCE inflation (Q4/Q4, percent)
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5.7
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3.8
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2.6
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Core PCE inflation (Q4/Q4, percent)
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4.8
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4.1
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2.8
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Unemployment rate (Q4 average, percent)
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3.6
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3.8
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4.4
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Current account balance (percent of GDP)
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-3.7
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-2.8
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-2.5
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Federal funds rate (end of period, percent)
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4.4
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5.4
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4.9
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Ten year government bond rate (Q4 average, percent)
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3.8
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4.0
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3.7
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Federal fiscal balance (percent of GDP)
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-5.5
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-5.6
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-5.7
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Federal debt held by the public (percent of GDP)
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97.0
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96.6
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98.4
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Important Near-Term Risks
The resilience of the economy and the robustness of labor markets are good
news. However, it is possible that the large and rapid increase in interest
rates that has already been put in place may not be sufficient to
expeditiously bring inflation back to target. With a large share of
household and corporate debt contracted at relatively long duration and
fixed rates, household consumption and corporate investment have proven
less interest-sensitive than in past tightening cycles. This creates a
material risk that the Federal Reserve will have to raise the policy rate
by significantly more than is currently expected to return inflation to 2
percent. On the positive side, near-term growth outcomes could be better
than currently anticipated. However, this would only mean that the economy
would slow more abruptly at a later stage (possibly in 2024), creating a
recession as tighter monetary policy takes hold. The combination of higher
U.S. interest rates, a stronger dollar, and a sharper slowdown in U.S.
activity would have significant negative macro-financial spillovers to the
rest of the world.
The downside risks associated with a less effective monetary transmission,
and a more protracted disinflation, could be further complicated by two
additional considerations:
First, a higher path for interest rates could reveal larger, more systemic
balance sheet problems in banks, nonbanks, or corporates than we have seen
to-date. Unrealized losses from holdings of long duration securities would
increase in both banks and nonbanks and the cost of new financing for both
households and corporates could become unmanageable. Such a tightening of
financial conditions could trigger an increase in bankruptcies, worsen
credit quality, and heighten stress for those entities carrying high levels
of leverage and with large near-term gross financing needs. These financial
stability problems could be further exacerbated if the functioning of the
Treasury market also becomes compromised. The longer that higher interest
rates persist, the greater the likelihood that such fractures will be
revealed. Recent failures of large, non-internationally active banks—which
have, so far, only had a modest effect on credit conditions—could
potentially be a prelude to more serious and ingrained systemic financial
stability problems.
Second, brinkmanship over the federal debt ceiling could create a further,
entirely avoidable systemic risk to both the U.S. and the global economy at
a time when there are already visible strains. To avoid exacerbating
downside risks, the debt ceiling should be immediately raised or suspended
by Congress, allowing negotiations over the FY2024 budget to begin in
earnest. Furthermore, a more permanent solution to this recurring stand-off
should be found through institutional changes that ensure that, once
appropriations are approved, the corresponding space on the debt ceiling is
automatically provided to finance that spending.
Fiscal Imbalances Remain Unaddressed
On a general government basis, fiscal policy is expected to be procyclical
in 2023. With the economy operating well above potential and inflation a
persistent problem, there is a strong case for greater fiscal restraint in
2023-24. A tighter fiscal stance would lessen the burden on the Federal
Reserve in disinflating the economy, potentially reducing the downside
risks outlined above.
Beyond the near-term need for fiscal tightening, a more significant
adjustment (i.e., an increase of around 5 percent of GDP in the general
government primary balance) is required to put public debt on a decisively
downward path by the end of this decade. It is worth noting that, even with
such an ambitious adjustment, debt would remain well above pre-pandemic
levels over the next decade.
Generating social and political consensus to undertake such an adjustment
will be challenging. However, precluding increases in the taxation of those
earning under US$400,000 per year or changes to social security and
Medicare will ultimately make such an adjustment infeasible. Rather, a
smaller federal deficit will require deploying multiple policies. Revenues
could be increased through a broad-based federal consumption tax, a carbon
tax, higher taxation of corporates and high-income individuals, scaling
back poorly targeted tax expenditures (such as for employer-provided health
care, sale of the principal residence, mortgage interest, and state and
local taxes), closing tax loopholes, reducing the minimum threshold for the
estate tax, and further improving revenue administration. Social security
benefits could be indexed to chained CPI, the income ceiling for social
security contributions could be raised and increases in the retirement age
could be more front-loaded. Health care costs could be lowered through
greater cost sharing with beneficiaries and changes in the mechanisms for
remunerating healthcare providers.
Maximizing the Benefits from Open Trade
Over the last few years, global concerns have been raised over the
resilience of supply chains, including as relates to national security.
In this context, the Inflation Reduction Act, the CHIPS Act, and the
Build America, Buy America Act have included provisions that are
explicitly designed to favor goods and services produced in the U.S. or
in North America. We know from experience that protectionist provisions
distort trade and investment and risk creating a slippery slope that
will fragment global supply chains and trigger retaliatory actions by
trading partners. As such, these “Made in America” policies are
ultimately bad for U.S. growth, productivity and labor market outcomes.
Rather than favoring domestic producers over foreign, the U.S. would be
better served by maintaining the open trade policies that have been vital
to boosting growth. In addition to instituting new preferences, the U.S.
has also kept in place many of the tariffs and other trade distortions that
were introduced over the past five years. These should be rolled back as a
means to facilitate similar reductions in tariffs by trading partners.
Trade policy would be better bolstered by increasing productivity and
competitiveness through investments in worker training, apprenticeships,
and infrastructure, thus lifting the ability of U.S. firms and workers to
compete internationally. The U.S. should actively engage with all major
trading partners to address the core issues that risk fragmenting the
global trade and investment system. This includes finding common ground in
areas such as tariffs, farm and industrial subsidies, and services trade.
It also includes ensuring that new trade initiatives are used to further
trade integration between trading partners, and not as discriminatory tools
that create incentives for fragmentation.
Finally, to better capitalize on the significant economic benefits that
multilateralism and open trade have brought the U.S. should redouble
efforts to strengthen the WTO. This would mean avoiding discriminatory
measures that undermine the rules-based trading system. It would also mean
working to restore a well-functioning WTO dispute settlement system by
2024. Taken together, these actions would help promote the trade policy
certainty that is essential to investment and growth.
Financial Stability Risks at the Forefront
Recent bank failures highlight the potential systemic risks posed by even
relatively small financial intermediaries. The past few months have focused
attention on poor risk management by individual institutions,
vulnerabilities created by the regulatory “tailoring” that was put in place
in 2018, and inadequate supervisory oversight. Important questions have
been raised about the insufficiently assertive stance taken by bank
supervisors as well as the effectiveness of the stress tests that were
undertaken to identify the extent of bank vulnerabilities and the potential
for systemic contagion. It has become clear that, despite correctly
diagnosing the vulnerabilities in the system, the actions that were
subsequently taken by supervisors neither prevented the most vulnerable
banks from continuing to grow rapidly nor precipitated fundamental changes
to these banks’ operations.
To better mitigate systemic risks, prudential requirements should be made
more stringent for mid-sized banks, subjecting them to similar requirements
as larger banks. Specific changes for non-internationally active banks
(i.e., Category III and IV firms) should include (i) subjecting them to
stress testing as part of the annual supervisory stress testing process;
and (ii) aligning their capital and liquidity requirements with the Basel
framework (including applying coverage of the liquidity coverage ratio and
the net stable funding ratio). More explicit rules and processes should be
instituted to escalate supervisory actions in the event a bank does not
undertake a timely response to address supervisory warnings. There would be
benefit in also strengthening the stress testing framework to examine a
broader range of possible scenarios and undertake integrated
solvency-liquidity stress tests. A more methodical process should be
adopted to assess banks’ exposure to interest rate risk—in both the
available for sale and the hold to maturity portfolios—and have a
supervisory response in cases where these risks are seen to be building.
More standardized disclosure requirements on interest rate risk may also
help. Finally, the practice of not applying margins to collateral at the
discount window (that were introduced in March) should be viewed as an
extraordinary step and, as such, should be discontinued when the Bank Term
Funding Program is scheduled to expire.
High leverage, liquidity and duration mismatches, as well as
interconnectedness between banks and non-bank financial institutions pose
additional risks. Flows into money market funds have accelerated following
the regional bank failures and there are risks that banks become
increasingly disintermediated. This reallocation across intermediaries may
encounter issues in market liquidity and functioning, with unpredictable
consequences. Furthermore, the various failures of crypto-related entities
illustrate the need for greater oversight of that sector, including from
the perspective of consumer protections. Finally, nonbank intermediaries
play an important role in commercial real estate including through real
estate investment trusts and commercial mortgage-backed securities.
Commercial real estate contains significant leverage, has important
near-term financing needs, is going through a significant adjustment to
changing patterns of demand, and may well come under pressure as regional
banks reduce exposure. This could, in turn, have uncertain spillover
effects to the nonbanks which merit further analysis and monitoring.
The last few years have seen U.S. fixed income markets prove to be
insufficiently resilient under stress. Data on the operations of the
Treasury market has been improving and a standing repo facility has been
established by the Fed to provide liquidity and contain upside spikes to
short-term interest rates. The interagency working group on Treasury market
resilience has put forward proposals to improve market functioning
including an expansion of all-to-all trading and greater use of central
clearing. Increasing dealer capacity to intermediate the Treasury market by
excluding Treasuries from the calculation of the Supplementary Leverage
Ratio may also help. Some of these have led to rule change proposals that
have been circulated for public comment. There now needs to be an effort to
translate this work into institutional changes that strengthen the
functioning of the Treasury market.
An Urgent Need to Invest in Supply Side Reforms
A range of policies were proposed in the President’s budget that would help
address supply side constraints to growth. These include:
- Tackling poverty by increasing the child tax credit, making it fully
refundable and advanceable, expanding the earned income tax credit for
workers without qualifying children, broadening Medicaid coverage, and
expanding nutrition support.
- Incentivizing greater labor force participation by providing more
federal resources for childcare and guaranteeing paid family leave for
private sector workers.
- Expanding healthcare coverage through tax credits for lower income
individuals that purchase privately provided health insurance.
- Increasing access to education including through universal pre-school,
subsidizing higher education for lower income households, and supporting
vocational training and apprenticeships.
- Improving progressivity by increasing income tax rates on high earners,
taxing carried interest as ordinary income, and ensuring that when
appreciated assets are given as a gift (or upon death), capital gains would
be realized and represent taxable income to the donor (or the decedent’s
estate).
- Revising the global minimum tax regime, adopting an undertaxed profits
rule, and limiting the scope for tax inversions.
- Limiting opportunities for tax avoidance by scaling back various
embedded corporate income tax incentives (including eliminating all tax
preferences for fossil fuel producers).
These proposed policies merit adoption but should be couched within a
medium term fiscal framework that puts debt-GDP onto a downward path.
Forward Momentum on Climate But There’s More To Do
Policies in the Inflation Reduction Act are a big step forward and have the
potential to decarbonize the U.S. economy, lowering greenhouse gas
emissions by around 36 percent by 2030 (relative to 2005 levels). However,
rapid deployment of green energy generating capacity and achieving the full
potential of the Act’s measures will hinge on overcoming implementation
challenges, such as delays in permitting projects and electricity
transmission siting.
Beyond this important policy package, more remains to be done to ensure
emission reductions reach the U.S. objective of a 50–52 percent reduction
by 2030. Additional steps could include a further tightening of state-level
or federal regulations (including on fuel efficiency or tighter regulation
of CO2 emissions from power plants), ensuring that the upcoming
reauthorization of the Farm Bill prioritizes changing incentives for carbon
intensive agriculture and supports carbon sequestration, and start building
the necessary social consensus to begin pricing carbon. The U.S.’s very
flexible labor markets will be an advantage in facilitating
decarbonization. Nonetheless, training and financial support for the most
affected workers would help facilitate a faster reallocation of labor and
lower societal costs of the transition. This would help ensure that reducing
emissions garners broad societal support and does not leave behind those
communities that are currently reliant on fossil fuels for jobs, activity,
and local tax revenue.