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FOMC’s Goldilocks projections overlook impending fiscal drag, especially from student-loan repayments

We expect US real GDP to grow above 4% QoQsaar in Q3CY23, inducing a further 25bp hike in the Fed Funds rate at the FOMC’s meeting on 1st Nov’23. At this week’s meeting, the FOMC’s median projections suggested a Goldilocks economy in CY23, with real GDP growing 2.1% (vs the projection of 1% in Jun’23) while core PCE inflation was projected to end CY23 at 3.7% (vs 3.9% previously). But the US economy has benefited from a persistent fiscal stimulus over recent quarters. This will be abruptly withdrawn in Q4CY23, with a cap on non-defense discretionary spending coming into force as part of the debt ceiling deal agreed in May’23, and student loan interest payments set to resume on 1st Oct’23. The consequent decline in personal consumption is still likely to tip the US into recession in Q4CY23-Q1CY24.

Resumed student-loan repayments to erode PCE from Q4CY23

The debt ceiling deal ended the moratorium on student-loan interest payments (which had been in place since Mar’20 as a form of covid relief). President Biden’s plan to write-off some student loans (estimated to total USD440bn) was deemed unconstitutional by the US Supreme Court at end-Jun’23. So, interest began accruing on the entirety of the USD1.6trn of student loans from this month, and interest payments will resume on 1st Oct’23. These are estimated to reduce the average individual’s disposable income by 8-9% in Q4CY23, thus eating into private consumption expenditure (the key pillar of US economic strength in recent quarters). 

Inverted yield curve will win, helped by strong USD

The USD is likely to continue rallying in nominal effective terms, gaining against the EUR and GBP as those central banks face less pressure to raise rates as headline inflation abates. While a weakening USD boosted the US economy in H1CY23, the stronger USD will be a drag on net exports in Q4CY23 – helping tip the US economy into the recession that has been telegraphed by the persistently inverted yield curve since Jul’22. We expect the recession, combined with the YoY decline in M2 throughout CY23, to finally help rein-in core PCE inflation to 3% YoY by Mar’24, allowing the Fed to resume cutting its policy rate in Q2FY24. 

Goldilocks economy implies smaller and later rate cut projections

The rate-setting Federal Open Market Committee (FOMC) chose to keep its policy rates unchanged at its Sep’23 meeting (as widely expected), but the committee’s median projections for the economy were revised substantially upwards. In particular, the real GDP growth projection for CY23 was revised up from 1% (in Jun’23) to 2.1%, while the CY24 projection was also raised to 1.5% (from 1.1% in Jun’23). Despite the much higher projections for growth, the core PCE inflation projection was lowered slightly, to 3.7% for end-CY23 (from 3.9% in Jun’23) and unchanged at 2.6% for end-CY24

This Goldilocks scenario (‘not too hot, not too cold’) would result in a soft-landing for the US economy, defying the persistent prediction of a recession indicated by the inverted yield curve. While the median FOMC projection remains for the Fed Funds rate to end CY23 at 5.6% (implying one more 25bp rate hike this year), the projection for end-CY24 has been raised to 5.1% (implying a 50bp reduction during next year, or just 25bp lower than the current Fed Funds rate).

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