US Industrial Production Outlook Revision

We revised our US Industrial Production forecast, eliminating the soft-landing expectation, which had been based on relatively strong consumer spending and real income excluding transfer payments, low credit delinquencies, and – on the business side – record profits, robust backlogs, and reshoring trends. Our analysis suggests that the Federal Reserve’s actions and economic COVID-echoes will pull in the contractionary cycle we had originally pegged for the middle of this decade.

In order to restore price stability, the Federal Reserve has pursued aggressive contractionary policy and has signaled its willingness to accept a weaker labor market and cooler demand as a trade-off. The Fed has increased the federal funds target rate by 375 basis points so far this year and has signaled that further rise is likely. High interest rates can deter demand in various sectors, including consumer goods, capex, and construction. Additionally, we have seen a sustained inversion between the 3-month Treasury yield and the 10-year Treasury yield (i.e., the long-term yield is running below the short-term yield). This signals that, according to the bond market, the Fed has likely gone too far.

While an inverted yield curve is not a direct cause of decline in US Industrial Production, it is a high-probability (about 88%) signal of upcoming, albeit not immediate, contraction. Given this signal’s range of typical lead times and the sum of other economic evidence, we anticipate annual Production will peak in the second half of 2023 and end the year very close to the year-end 2022 level. Subsequent decline will extend through 2024. Decline will be relatively mild by recent historical standards, given the aforementioned and still-relevant positive elements that had undergirded our pre-revision forecast.

Annual Production will decline below year-ago levels, entering Phase D, Recession, in early 2024. This trend will extend into late 2024, at which time Production, though still declining on an annual basis, will enter Phase A, Recovery.

We built the new forecast with the assumption that the Federal Reserve will cease raising rates in the first half of 2023. If the Fed continues to raise rates thereafter, Production decline may be steeper or more prolonged. If high interest rates are less of a hindrance to consumer and business spending than anticipated, Production could outperform our forecast.