S&P Global Ratings expects the U.S. economy to expand 2.7% in 2024 and 1.8% in 2025 (on an annual average basis). The growth forecasts are 0.2 and 0.1 percentage point higher, respectively, compared with our June forecasts, partly reflecting the impulse from financial conditions that turned more positive and partly on stronger core goods consumption than previously expected.

On a year-end basis, we expect growth to come in at 2.0% in the fourth quarter of 2024, down from 3.1% in fourth-quarter 2023.

Chart 1

Aside from continued sluggishness in the housing and manufacturing sectors, most recent activity indicators suggest economic growth momentum continues to run slightly above trend, though it has moderated since the fourth quarter of last year.

The recent loosening of the labor market indicates a normalization, as opposed to a U.S. economy that's about to slip into recession. An expansion of the labor force, rather than a fall in employment, has spurred the rise in the unemployment rate up to now--a key difference from previous cycles at the start of a recession.

Still, real income growth has softened, and there are signs of slowdown in discretionary consumption. Our base case embeds no changes in tax policy because, like in the past, especially when it comes to personal income taxes, policymakers compromise to avoid sunset clauses (which are set to expire at the end of 2025 under the Tax Cuts and Jobs Act of 2017). But, the public sector's direct contribution to GDP and employment growth is likely to be tempered (outside of continued impulse on the infrastructure side) as earlier strength of state and local government finances last year has faded as revenues slowed and as constraints from balanced budget rules become more binding. Businesses continue to face higher costs of capital and policy uncertainty in the near term, which will limit capital expenditure and hiring, and the unemployment rate will likely rise in the next several quarters--to 4.5% by the end of 2025, from 4.2% currently.

Table 1

We forecast inflation to slow further in the coming months. Labor market normalization has helped bring down growth in unit labor costs (and increase labor productivity). Measures of inflation expectations by the households, businesses, and financial markets remain consistent with the Fed's 2% target. The path will remain bumpy, but annual inflation should hover within striking distance of 2% in 2025, notwithstanding unforeseen supply shocks.

Monetary policy is not on a preset course. Still, as the inflation target appears to be more and more achievable, the Fed's risk management calculus has changed to become more concerned about the downside risks to the labor market. As such, in its September policy meeting deliberations, the Fed signaled it is strongly committed to not see the labor market loosen much further, as evidenced by the 50-bps rate cut on Sept. 18 and subsequent "direction of travel" projected over the next several quarters. Consistent with our macro forecasts and our reading on the Fed's response function, we now anticipate 50 bps more easing in 2024 followed by another 125 bps easing in 2025.

Chart 2

The data suggests that the Fed's policy rate does not need to be as restrictive as it is, but there is enough strength that aggressively easing monetary policy is not yet warranted. A gradual 25-bps cut per meeting to get to neutral seems reasonable to us. However, given uncertainty surrounding the estimate of the (unobservable) potential neutral rate, our conviction on the path of rate outlook is not strong. The risk to our baseline assumption is that there may be more front-loaded cuts and that easing may be slower in the spring and beyond as rates get closer to potential neutral range (which the Fed pegs at 2.5%-3.5%). Front-loaded cuts run a higher risk of inflation overshoot and odds of a policy correction.

We also revised up our growth forecasts for 2026 and 2027 slightly as potential growth has risen. Our baseline forecast envisions the positive output gap will close by 2027 (see chart 1). For the U.S. economy, the Congressional Budget Office estimated real potential output growth to be 2.1%, on average, for 2024-2029, versus 1.8% earlier, mostly reflecting a higher-than-anticipated rate of net immigration from 2021-2026.

Chart 3

Recent Economic Developments: Still Solid Domestic Demand

Real GDP grew at a 2.2% annual rate in the first half of this year, and the average of several real time running estimates of GDP is tracking 2.5% growth for the third quarter. Real final sales to private domestic purchasers, a measure of private domestic demand, grew at a solid 2.8% annualized pace in the first half of the year.

As for the growth picture based on high frequency real time data, the Weekly Economic Index (WEI) by the Dallas Federal Reserve (previously by the New York Fed) is currently 2.3%, scaled to four-quarter GDP growth, for the week ended Sept. 12. This is lower compared with 3.1% four-quarter GDP growth through the second quarter of 2024, but still solid.

Consumer spending

Strong core retail sales in July and August and rebounding motor vehicle sales in July have consumer demand holding steady in the third quarter. But not all of consumer data has been strong. Within the retail sales report, real restaurant sales (part of services consumption and a measure of discretionary spending) remain weak, tracking down to a 2.25% annualized rate in third quarter-to-date (which would be the third straight quarterly growth slowdown).

Our current estimate for consumer spending is a robust 3.5% annualized for the third quarter, which would be the fastest pace of personal consumption expenditure (PCE) growth since first-quarter 2023. But with the labor market showing clear signs of cooling, real income growth running behind real spending growth since the middle of last year, the household savings rate at a two-year low, and delinquency rates for credit cards and autos above pre-pandemic levels and still edging higher, we expect consumers will likely rein in their spending in the coming quarters.

Chart 4

Business investment spending

Industrial production remains flat in the third quarter over last quarter, with an autos-led rebound in August following a decline in July. The 0.9% month over month increase in manufacturing production (mining, utilities, and manufacturing make up overall industrial production) was largely due to a 9.8% jump in motor vehicle and parts production. This jump was likely, given it slumped by 8.9% the month before because of temporary plant retooling shutdowns. As vehicle sales dropped back in August, the strong rise in motor vehicle production will not be repeated. Aerospace production, which rose 1.2% last month, will also be weighed down this month by the ongoing strike at Boeing. Added to the fact that the survey-based manufacturing activity indices (from the regional Feds, Institute for Supply Management [ISM] and S&P Global) all remain muted, it is not yet convincing that this is the beginning of a cyclical recovery in the manufacturing sector.

Chart 5

As for capital expenditure (capex) spending more broadly, business spending is shaping up for a solid third quarter of growth. Aircraft shipments are leading strength in equipment investment. Nondefense capital goods shipments rose nearly 5% in July, and when excluding aircraft, shipments were down modestly (-0.3%). Uncertainty around both the degree of Fed easing and the outcome of the 2024 U.S. presidential election are key factors holding back capex today. Fed easing should provide some support to capex spending generally, although with a lag. We see capex spending rising at a decent clip next year. For 2026, we have real equipment running in line with pre-pandemic growth rates.

Investment outlays on nonresidential structures should continue to be supported by a high-tech building boom, concentrated in the computer, electronic, and electrical (including semiconductors) manufacturing sector (largely because of supportive fiscal policy [CHIPS Act passed in 2022]). Still, headwinds from commercial construction (as indicated by the Architectural Billings Index) points to slower overall private nonresidential construction outlays in the near term. We look for intellectual property products spending to remain robust amid sustained support from a transition to automation and technological advancements.

Residential investment spending

The near-term outlook for fixed residential investment remains weak as high financing costs continue to challenge multifamily development. In addition, single-family construction was also declining until the recent pickup in August. The large rise in housing starts in August was due to a rebound in starts in the south, confirming that the July slump was a temporary disruption caused by Hurricane Beryl. The increase in permits, particularly in the single-family sector where issuance had been falling, suggests starts will likely grind up from third-quarter averages, helped by a single-family-led recovery in new construction in the final months of the year. With Fed easing and a subsequent relief in financing costs on the horizon, the outlook for residential investment should improve next year.

Inflation

Inflation continues to approach the 2% goal. Outside of the shelter component, the stickiness of which continues to surprise on the upside even as supporting real time rent inflation indicators have fallen sharply, core inflation is running close to its pre-pandemic pace. Energy prices continue to help, core goods are still showing deflation, and food prices have stabilized.

Chart 6

Chart 7

We continue to think annual inflation should converge to 2% in 2025 for two main reasons. First, normalization of the churn in the labor market--indicating a better balance in supply and demand of labor--has helped bring down wage growth and unit labor costs while keeping labor productivity growth steady. Second, we also assume the lag of shelter price disinflation (versus the sharp fall in timelier measures of rent inflation) will kick in. (An aside: The recent decline in energy prices, if persistent, could be another source of overall disinflation. The WTI crude oil benchmark is recently running near $70, which is below our assumption of $80 for the rest of the year and $75 thereafter.)

Lags in transmission

The cumulative monetary policy easing that we have penciled in over the next several quarters is likely to keep growth from slipping too far below the growth of potential output, which is the amount of real GDP that can be produced if labor and capital are employed at their maximum sustainable rates. Any stimulative effect from monetary policy easing is likely to come with a long and varied lag (and there is no consensus on just how long that lag is).

There is very little precedent of the Fed cutting when there is no downturn. Similar to now, recalibration cuts occurred in 1966, 1995, 1998, and 2019. And so, in some ways, it's hard to really separate how much rate cuts are doing when you already have a lot of other negative forces.

Still, there are a couple negative effects to consider before we see any stimulative effect from rate cuts. First, a reduction in short-term rates would immediately reduce interest income on money market funds and certificates of deposit, which generally tend to affect older and more affluent households. Second, potential borrowers may wait for further rate cuts before making any borrowing decisions. It may only be later in the easing cycle when rates look like they are near cycle lows that the real stimulative effect kicks in.

Third, specific to this particular cycle, the fixed mortgage rate lock-in effect undermines the effectiveness of monetary policy easing. According to analysis done by the Swiss Re Institute, the structure of the U.S. mortgage market--where over 95% of home loans are fixed-rate mortgages and more than half still pay less than 4% (while 40% of homeowners have no mortgage at all)--meant the large gap between the spot market rate and the effective existing mortgage rates lowered monetary policy effectiveness during the hiking phase by supporting consumer resilience. It is now also likely to have reduced the stimulus effect until that gap is closed meaningfully.

The Fed Pivot: From Inflation-Focused To Employment-Focused

One key change in our baseline forecast since June is an acceleration in the pace of monetary policy easing. We anticipate the Federal Reserve to deliver two more rate cuts of 25 bps each at the remaining policy meetings in 2024, and a total of 225 bps of rate cuts by the end of 2025 (75 bps more by year-end 2025 than our prior expectation).

The change In our assumption for the fed funds rate path is in response to the Fed's desire, as stated by Chairman Jerome Powell in his Jackson Hole Symposium speech, to prevent further cooling of the labor market.

Payroll growth has trended lower, together with other labor churn metrics, in 2024. The economy added 142,000 net new nonfarm payroll jobs in August, which was slightly below consensus, and job gains of the prior two months were revised down. In the past three months, payroll gains have averaged 116,000, which is not only considerably below the 202,000 average during the prior 12-month period, but also below the near-term breakeven pace that would keep the unemployment rate steady (see chart 8).

Chart 8

But more than that, the Bureau of Labor Statistics' (BLS) unfavorable data revisions for nonfarm payrolls (and uncertainty around the direction of further revisions) has increased worries around risks to employment.

The revisions showed payroll employment in March 2024 was 818,000 lower (all in private sector) than what had been previously stated. It was the second-largest revision in history (2009 had a downward revision of 824,000). The revisions will appear in the January Employment Situation report (in the first week of February 2025). The upcoming payroll employment revisions will show payroll employment increasing 1.3% over the 12 months ending in March 2024 (similar to 2019), down from the current estimate of 1.9%. The revisions imply that monthly nonfarm payroll gains from April 2023 to March 2024 averaged around 174,000 per month, rather than the 242,000 that the current data shows. (Revisions are based on the Quarterly Census of Employment and Wages (QCEW) report. It relies on unemployment insurance record—-which undocumented immigrants can't apply to. As a result, we suspect the revised data is likely to have stripped out thousands of unauthorized and authorized-uninformed workers that were included in the initial payroll estimates.)

The downward revision also means that labor productivity is likely to be revised higher instead because the revisions don't necessarily mean that GDP growth will be revised down. However, it may still be revised down during the upcoming annual update to GDP statistics for the previous five years because an alternative measure of GDP growth--one based on income--is running meaningfully below expenditure-based GDP growth. Nevertheless, it has amplified the Federal Reserve's concerns about the continued strength of the labor market.

Is The Unemployment Rate Signaling A Recession?

Meanwhile, the unemployment rate, which comes from a different survey (household survey), edged down by 0.1 percentage point to 4.2% as a stronger gain in number of employed outstripped a further increase in labor force. The unemployment rate partially reversed some of July's uptick thanks to a sharp reversal in temporary layoffs following a spike in July. Wage gains in August were robust at 0.4% during the month, translating to a 3.8% gain for the 12-month period.

Chart 9

Chart 10

The increase in the unemployment rate this year has almost entirely come from the surge in labor force entrants and temporary layoffs. The number of people who lost their jobs for "permanent" reasons (as opposed to "temporary" reasons) has essentially been flat this year, accounting for very little of the rise in the unemployment rate--we think this is more representative of the underlying condition of the labor market. And there has been very little change in the number of people who aren't in the labor force currently but say they want a job.

Several other indicators show the labor market has normalized to where it was in 2018-2019. The ratio of job openings to the number of people who are unemployed, the quits rate, the job openings rate, and layoffs are signaling that labor demand has cooled slightly, to levels we were accustomed to before the pandemic. Unemployment insurance claims remain relatively low, though continued and initial claims combined have recently been drifting higher.

Up to now, normalization has occurred through a large decline in the job openings rate, instead of through layoffs. We've moved down the steep post-pandemic Beveridge curve. It's not clear yet if we've reached an inflection point where a further loosening of the labor market would come through layoffs, not just through a decline in open positions.

Chart 11

Clearly, the labor market has cooled over the past year, but we don't see enough evidence to suggest that the recent softening is the start of a more serious deterioration in underlying fundamentals.

Probability Of A Recession

The recession question is often top of mind with investors and policymakers when the economy is running a positive output gap and monetary policy is in restrictive territory.

We continue to think the probability of a recession starting within the next 12 months remains elevated, around 25%. This is unchanged from three months ago, even as a couple of past empirical regularities--the slope of the yield curve and trend of unemployment rate--have moved since our last forecast in a way to suggest higher probability of a recession.

As with any statistical relationship, past empirical regularities preceding a recession must be scrutinized for their reliability in the current cycle, especially given the unique features of this expansion coming out of the pandemic.

Historically, the time between the first month of an inversion and the start of a recession has ranged from six to 18 months. The yield curve disinverts just before a recession begins. However, this time may be different because this expansion is coming out of a pandemic-induced recession, rather than a more typical recession caused by the business cycle or financial markets. Fiscal policy response (much looser for longer) has been another differentiating factor. Moreover, the Fed's balance sheet policy since the global financial crisis of 2007-2009 may be distorting the usual signal through compressed term premium.

The current yield curve inversion primarily reflects investors' expectation the Fed will eventually have to cut interest rates, which in turn may reflect the following:

• A view that the Fed will go too far and push the economy into recession, or
• A view that the Fed has pushed the policy rate above its expected long-run average and that its success in bringing down inflation will allow it to reverse course.

Our long-held view has been the latter may be the case this time.

Meanwhile, the Sahm rule indicates a recession is coming if the unemployment rate rises more than 0.5 percentage point compared with the low of preceding 12 months (like all nine recessions since 1945). But this time the rise wasn't because of falling employment, but rather from labor force rising quicker than employment.

We find it helpful to put the current business cycle in the framework of three types of recessions (see "Framework: Cyclical Risk Profile"). Of the three types of risks, it appears to us that policy-induced recession risk is more elevated than usual. Desire to not keep elevated degree of monetary policy restrictiveness (appearing more dovish than our previous reading) naturally lowers the odds of a recession. However, data revision showing smaller gains in employment (appearing softer than our previous understanding) puts the economy at a weaker state than previously understood, and the shakiness of data raises the odds of policy mistake.

Risks To Our Forecasts Are Balanced

In the near term, the Fed will remain focused on the economic data, in terms of how risks around employment and inflation influence the monetary policy outlook and to gauge the resilience of domestic demand and the labor market. While the economy's underlying growth potential will constrain any rise in spending, the lagged impact from fiscal policy should limit a cyclical slowdown in GDP growth.

The Federal Reserve's latest Financial Stability Report--showing private-sector balance sheets are sound--provides some comfort but also comes with a warning about the debt-servicing capacity of smaller, riskier businesses in case of a sharp downturn in economic activity.

Ordinary risks to our baseline growth forecasts are slightly tilted to the upside for 2024 and are nearly balanced for 2025. Ordinary upside risks emanate from continuing strength in both private- and public-sector consumption while downside risk comes from consumers being more cautious in spending than what our baseline projects (see tables 3-4 for our optimistic and pessimistic scenarios).

Key extraordinary downside risks include:

• Geopolitical risks to macroeconomic outcomes (including, more recently, the heightened tensions between Iran and Israel) remain elevated, although the impact so far has been contained.
• A potentially disruptive U.S. election outcome also looms.
• A disorderly reaction in the financial markets to actual and perceived risks--if it persists--would lead to a higher chance of a recession as companies respond to a sustained tightening of financial conditions by cutting back on investment and headcount.

We also often get asked about risks to the baseline macroeconomic outlook from potential additional tariffs. Without getting into a specific scenario, at a high level, tariffs come with upside risk to the inflation forecast and downside risk to GDP growth. The exact magnitude depends on how the tariff is structured, what other policies (both fiscal and monetary) are put in place to counteract negative implications, how the tariff revenue is used (is it subsidizing another sector?), and how the rest of the world responds. From the perspective of businesses, tariffs on final goods protect U.S. final goods producers (but are not good for U.S. consumers), but tariffs on intermediate inputs they need for production harm them.

Cost competitiveness of U.S. firms will be harmed more if final goods don't get additional tariffs (presumably to shield consumers) but intermediate inputs do. U.S. businesses' cost of production goes up while having to still compete with imported final goods. For importers, universal tariffs hurt more than concentrated tariffs as there is no avenue to capitalize on via rerouting or substituting.

Table 2

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Table 4