The outlook for fourth-quarter GDP growth improved dramatically in recent weeks, especially following a sharp narrowing of the trade deficit in November.

We currently estimate that GDP rose at a 2.8% annual rate in the fourth quarter, following 3.2% growth in the third quarter. Since Dec. 23, we have revised up our estimate of fourth-quarter growth by nearly two percentage points, with the bulk of that accounted for by a massive upward revision to the change in net exports of $96 billion. Revisions to data on construction spending also contributed to the upward revision to the fourth quarter.

The narrative of our near-term outlook for the US is still one of mild recession beginning in the first quarter of 2023, with a peak-to-trough decline in GDP of 0.6%. Fed tightening, which will continue and reinforce the tightening of financial conditions over approximately the past year, will weaken demand in both product and labor markets, pushing up unemployment and reinforcing a downward track to inflation.

A necessary weakness

In our view, a period of economic weakness that results in rising unemployment will be necessary to temper inflationary pressures sufficiently to bring inflation all the way down to the Fed's 2% inflation target in a sustained fashion.

Labor markets remain very tight as labor demand is strong but with hints of moderation. During December, payroll employment expanded by 223 thousand, the unemployment rate edged back down to 3.5%, matching its lowest reading immediately before the pandemic, and civilian employment as measured in the household survey surged by 717 thousand. Job vacancies are down approximately 12% from the peak last spring, but there was no decline in vacancies between August and November, as the ratio of vacancies to the number of unemployed remained extraordinarily high at 1.74.

There were hints in the latest employment report that growth in labor demand, while solid, is easing, including declines in the average workweek and hours worked for the second consecutive month, alongside a gradually declining trend in monthly payroll gains. Growth in average hourly earnings has trended down, with an annualized increase over the last 3 months of 4.1%.

Seeking sustained moderation

The Fed would welcome a sustained moderation in growth of labor costs to be more consistent with the trend in productivity and its long-term 2% inflation target. The minutes of the last policy meeting of the Federal Open Market Committee (FOMC), which concluded on Dec. 14, reinforced the Fed's intent to keep both feet on the brakes for some time. Additional Fed rate increases in early 2023 are certain.

Barring a quicker-than-expected reduction of inflation, the Fed will maintain a significantly restrictive policy stance throughout 2023 and into 2024. We assume a pair of quarter-point Fed rate increases at upcoming meetings that conclude on Feb. 1 and March 22, which would bring the upper end of the target range for the federal funds rate to 5%, where we expect it to remain until rate cuts begin in spring 2024.

The key hurdle for rate cuts will be clear and compelling evidence that inflation is falling in a persistent fashion, supporting a high degree of confidence that inflation will fall to 2%. Policymakers at the FOMC are generally less sanguine about the inflation outlook in 2023 than are we and generally anticipate a slightly higher peak target for the federal funds rate near 5¼%.

Optimistic investors

Investors are much more optimistic about falling inflation, supporting market-based expectations that the FOMC will begin cutting interest rates by this fall. (No FOMC participant expects to lower interest rates prior to 2024.)

2022 marked a year of substantial tightening in financial conditions prompted by Fed policy actions, including rapid increases in overnight interest rates and shrinkage in its roughly $8 trillion bond portfolio beginning in June.

For the year, the S&P 500 fell 19.7%, the benchmark 10-year Treasury yield rose 236 basis points to 3.88%, and the broad, trade-weighted value of the dollar finished the year with a 5.4% increase. At the trough this fall, the S&P 500 was down 25.1%. At their peaks last fall, the 10-year yield was up 273 basis points, and the trade-weighted dollar was 11.5% higher than at the end of 2021.

This week's economic releases:

• Consumer price index (Jan. 12): We estimate that CPI was unchanged in December and that core CPI, which excludes the direct effects of changes in food and energy prices, rose 0.4%. This could be a hopeful sign that the early stages of disinflation may be upon us.
• University of Michigan Consumer Sentiment Index (Jan. 13): We estimate the level of consumer sentiment at 60.5 in January, compared with 59.7 in December. Inflation, a major source of drag on sentiment, continues to ease.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.