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If it Walks Like a Duck and Quacks Like a Duck…

Rate hikes are a crude tool, lacking the precision necessary to land the economy.

Special Annual Outlook Edition

The U.S. economy contracted 0.9% in the second quarter after falling 1.6% in the first quarter. Historically, a two-quarter drop in real GDP growth was a sign that the economy was in recession. We are not in a recession—yet. The resilience of employment, consumer spending and production in the first half of the year allowed the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), the official arbiter of recessions, to give us a pass.

The surge in employment in July is another sign of the economy’s resilience. The establishment survey suggests we generated more than a half million jobs in July, an acceleration from an upwardly revised June. Average hourly earnings also accelerated. That is a lot of new paychecks to support demand at a time when the Federal Reserve wants to see demand slow further to better align with a supply-constrained world.

Costs continue to escalate. Quit rates held close to a record high in June, while the number of workers out sick due to the high rate of Omicron infections surged. The ranks of those out sick and unable to work in July was 60% above what we saw in any month pre-COVID, which adds to staffing shortages.

Those shifts help explain why the Federal Reserve Chairman Jay Powell argued that more rate hikes and an additional slowdown in demand would be “necessary” to derail inflation. The bulk of the effects of recent rate hikes are still ahead of us, while the level of rates is still too low to prompt a U-turn in the labor market.

That begs the questions: Why do so many Americans feel like we are in a recession? And second, if we are not in a recession now, is one likely?

The answer to the first question is easy. Most consumers are losing economic ground, even though they are still employed. Inflation is eroding all that most were able to gain in wage hikes earlier in the recovery and then some. The stress is so acute for low-wage households that credit defaults, which typically rise with an increase in unemployment, are already moving up.

The answer to the second is more complicated. Most within the Federal Reserve believe that the noninflationary rate of unemployment has moved up to between 4% and 5%.

The Fed is not inclined to say it is using rate hikes to trigger a recession. However, a rise in unemployment of that magnitude over a three-month period or more would constitute a recession. A larger increase in unemployment would be necessary to derail the inflation we are enduring. If it walks like a duck…

Fed Chairman Jay Powell has no illusions about the trade-offs he faces. When asked whether a recession was the greatest risk to the economy, he responded, “The bigger mistake would be to fail to restore price stability.”

The sizzling hot employment report for July only hardened his resolve. He remembers the 1970s. He knows that prolonged inflation is like cancer; if left untreated it can metastasize into something much worse. Treating it is also painful but better than the alternative. (Been there.)

This edition of the monthly outlook lays out how a mild but prolonged recession might play out. Special attention is paid to how the slowdown is likely to affect different sectors of the economy, what that means for the cooling of inflation, rate hikes and the collateral damage to financial markets. The bond market has been particularly sanguine about how rapidly the Fed can get inflation down and get back to cutting instead of raising rates. Brace yourself for reality to set in.

2022-24 Outlook

The Economy Stalls

Chart 1 lays out the trajectory for the economy through 2024. Our base case shows the economy stalling out and unemployment gradually rising until inflation cools and the Fed can start cutting rates again in late 2023 and early 2024. A faster cooling of demand would require even more aggressive rate hikes, a faster surge in unemployment and deeper potential wounds to the broader economy.

Chart 1: Growth stalls below trend

GDP, 2012 $, Trillions

Chart 1: Growth stalls below trend

GDP, 2012 $, Trillions

Source: KPMG Economics, Bureau of Economic Analysis

Consumers Feel Constrained

A pivot from spending on goods to services is expected to keep spending going over the summer. Travel and tourism are strong, but the big area to watch is health care. Many are still scrambling to catch up on routine exams and elective surgeries delayed by the pandemic. This is in addition to the surge in long COVID cases, which will further stress the health care system. (I am still trying to get my arms around monkeypox and how that will play out for the labor market and distort demand for services.)

A rapid drawdown in the savings amassed during quarantines, high inflation, rising interest rates and an eventual increase in unemployment suggest that consumer spending will further weaken as we move into 2023.

Separately, there is the unwinding of spending on goods we saw as the pandemic took hold and home buying soared. We have already bought much of the stuff needed to work from home and to ease the monotony of quarantines. Now we will see a downdraft in demand for home remodeling and big-ticket household goods; that includes spending on vehicles.

We were already skating on thin ice in the second quarter of the year, with consumer spending growing at an anemic 1% annualized pace after adjusting for inflation. That is about as close to zero as one can get without completely stalling out. A couple of negative quarters can’t be ruled out.

Housing Collapses

Home buying and building are the most interest-rate sensitive of sectors and have already plummeted. A 20% drop in pending home sales and an 11% drop in single-family permits in June suggest that the worst is still ahead of us.

Even investors, who were paying cash and snapping up homes sight-unseen to flip, are pulling back. Those shifts and a surge in cancelations for homes to be built are eating into backlogs.

Making matters worse for the Fed are housing shortages. That has buoyed prices and increased the demand for rentals, which remain in short supply. Investors are still buying houses to rent. The result has been an acceleration in shelter costs.

Problems in the tech sector mean that some of the hottest relocation markets in recent years will be hit hardest; Austin, Boise and Charlotte are in that mix. That is not enough to derail the upward pressure on ownership costs in the pipeline. It takes a year or longer for the initial rise in home values to show up in inflation measurements; home values were still accelerating in the first quarter of this year.

The silver lining is improvements in underwriting, which have left homeowners and lenders with a larger cushion in equity than we saw when the bubble of the early 2000s burst. Properties that slip into default should still be able to be sold at a premium. That is the opposite of the surge in underwater mortgages in the wake of the subprime crisis.

Businesses Pull Back

Business investment is poised to pick up a bit after pausing in the second quarter. Many of the supply chain problems triggered by lockdowns in China have begun to be resolved. That opens the door for some catch-up in economic activity in the second half of 2022.

Prospects for 2023 are not as good. Additional rate hikes, a strong dollar and weakness abroad are expected to take a larger toll on investment in 2023.

Large banks are already tightening credit standards to avoid big losses, while deals that made sense when rates were zero are now being abandoned. Even venture capitalists and private equity investors are growing more cautious. Unicorns are seeing much of their funding disappear.

The silver lining has been investment in intellectual property. That includes business and nonprofit investment in R&D, software and entertainment, literary, and artistic originals. It represents the backbone of innovation. Even there, we could see some weakness given the drop in streaming so many relied upon to weather the storm of lockdowns.

Inventories Drain

Inventories fell in the second quarter after ballooning in late 2021. The problem is that the overhang is still high relative to demand, especially in the retail sector. Manufacturing inventories look more balanced. The former has prompted discounting by big-box retailers. This is known as the bullwhip effect and should alleviate some of the upward pressure on goods prices.

The overhang of inventories is likely to challenge the shift from just-in-time to just-in-case inventory systems. Storing inventories is costly. Big-box retailers are already attempting to leverage their market power and shift more of those costs onto their suppliers.

Government Spending Rises

Federal government spending is poised to continue to shrink in 2022 as the effects of pandemic aid play out. We have not included any additions for the scaled-back, Schumer/Manchin compromise; the annual spending is a rounding error on the federal budget and partially offset with some tax increases.

Much like the infrastructure bill, much of the bill will take time to ramp up. The full effects of the infrastructure bill are not expected to show up in government spending until the mid 2020s.

State and local government spending, which represents the lion’s share of government spending, is expected to have more impact. State and local governments have yet to spend the windfall gains in tax revenues they received as employment surged and spending on goods and homes soared.

That is in addition to the savings school districts accrued as they pivoted to online from in-person and the transfers to states in the last round of pandemic aid in 2021. Some of those gains are being banked in rainy day funds. Others are being held up due to constraints on how aid can be spent. Many states are still trying to figure out how they can stay within the framework laid out by the federal government when using those funds.

Any state that can is cutting or temporarily eliminating taxes on food, energy and even things like school supplies. They are also issuing tax refunds to blunt the blow of inflation. That makes for good politics but further complicates the Fed’s goal to cool inflation via weaker demand.

Trade Deficit Waffles

After widening sharply in the first quarter, the trade deficit narrowed in the second quarter. The question is whether it can stay there. A strong dollar and a more resilient economy in the U.S. than abroad suggest the trade deficit will widen in the second half of 2022.

A sharper slowdown in the U.S. in 2023 could reverse those trends and allow the trade deficit to narrow a bit. Imports are expected to weaken more than exports next year.

The wildcard is China. Increased tensions with the U.S. and Taiwan have upped China’s military exercises in the Taiwan Strait, which is disrupting global trade flows. There is the potential it could be more consequential.


Risks are stacking up to the downside. The bulk of the slowdown triggered by recent rate hikes by the Fed are still ahead of us. The Fed is still raising rates and will not know it has gone too far until it has. This is in addition to the speed of rate hikes, which in-and-of themselves are destabilizing, and reductions in the Fed’s bloated balance sheet. The latter do not hit their stride until after Labor Day.

Inflation Simmers

Chart 2 provides the outlook for overall and core (excluding food and energy) Personal Consumption Expenditures (PCE) index over the next year and a half. It will take some time for inflation to return to the Fed’s 2% target:

  • The recent drop in prices at the gas pump will take some of the steam out of month-to-month increases in overall inflation. However, the rise in gas prices relative to a year ago remains high. This will put a floor under how rapidly overall inflation cools.
  • Discounting by big-box retailers and the slowdown in housing will help alleviate the upward pressure on goods prices.
  • A surge in the value of the U.S. dollar should exacerbate the slowdown/drop in import prices.
  • The sticking point is service sector prices. Shelter costs still have room to run. Home values have only begun to slow but it takes at least a year for those shifts to show up in home ownership costs, while rents are still skyrocketing.
  • Medical costs have begun to rise. COVID was costly and upped the risk of consolidation in the health care sector; staffing shortages remain acute and backlogs on more profitable and inflationary elective surgeries remain large.

This is at the same time uncertainty is high regarding additional supply shocks. My friends in the intelligence community have not ruled out more aggressive moves by President Vladimir Putin to weaponize oil exports, while military exercises in the Taiwan Strait underscore the breadth of geopolitical risks we are facing.

Separately, the frequency of extreme weather events is accelerating due to climate change. That is further disrupting supply chains and exerting upward pressure on prices. The recent flooding, damage to property and disruption to businesses in Appalachia and fires and drought in the West are only a few examples.

Chart 2: More Than a Year to Fed's Target

Percent Change, Annualized Rate

Chart 2: More Than a Year to Fed's Target

Percent Change, Annualized Rate

Source: KPMG Economics, Bureau of Economic Analysis


Inflation could remain more persistent than hoped. Another external supply shock could further unmoor inflation expectations and more permanently distort the behaviors of households and firms.

Powell addressed the risk of such a scenario at his press conference following the July FOMC meeting. “The public doesn't distinguish between core and headline inflation in their thinking. So, it's something we have to take into consideration in our policy making even though our tools don't really work on some aspects of this, which are the supply side issues.”

Fed Doubles Down

Chart 3 shows the forecast for the fed funds rate during the remainder of 2022 and 2023. The Fed is expected to raise rates to 4% by year-end and hold them there through much of 2023:

  • Chairman Powell left the door wide open to additional rate hikes at the press conference following the July meeting.
  • Other members of the Fed have underscored they are far from done.
  • The focus has pivoted to derailing inflation more than supporting employment; most believe a rise in unemployment is necessary.
  • The Fed fears repeating the stop-and-go policy errors of the 1960s and 1970s, even if that means a more dramatic slowdown or recession.
  • The Fed’s credibility on inflation has been damaged, which has upped its resolve to restore it.

Getting core PCE inflation, the best predictor of future inflation, down to 4% from 6% will be easier than lowering inflation to the Fed’s 2% target. Discounting in the goods sector should lower year-on-year measures of inflation.

The problem is the persistence of inflation in the service sector. The goal is to get inflation low enough that it no longer distorts decisions on spending by households and firms.

Chart 3: Higher for Longer

Target Fed Funds Rate

Chart 3: Higher for Longer

Target Fed Funds Rate

Source: KPMG Economics, Federal Reserve Board


The Fed can’t grow food or pump oil but it can hammer demand to meet a chronically undersupplied world; that is what it intends to do.

The Fed has never used its mammoth balance sheet to tighten credit markets. No one, including members of the Fed, knows how reductions in its balance sheet will accelerate the tightening of credit. I have likened it to driving backward with using the rearview mirror without the chips needed for sensors and cameras; you don’t know what you might hit.

Rapid rate hikes, as we currently see, are destabilizing. Low rates enabled a lot less than stellar business plans to be funded and advanced. (I am being diplomatic.)

Financial Markets Remain Volatile

The yield on the 10-year Treasury bond is currently below that for the two-year Treasury bond. That typically occurs when the bond market is convinced the economy will go into a recession. Until recently, the bond market expected any slowdown to be short-lived; bond market participants were betting that the Fed would be back in the game of cutting rates by the start of 2023.

That no longer looks like a good bet. Rate hikes are now expected to be much higher for longer than many had hoped. In response, financial markets are expected to remain extremely volatile over the next 12 to 18 months. The yield on the 10-year bond is expected to peak at close to 3.25% in 2023 before falling back below 3% by year-end in 2023.

Equity values are also expected to bounce around, as the squeeze of higher rates and escalating costs collide with weak demand. Our model suggests that a mild recession triggers a roller coaster ride for the broader stock indices but they should end 2023 higher than they are today.

That is not exactly reassuring given the bull run we saw in equity prices before the most recent tightening cycle by the Fed. Higher rates have a way of revealing the sins that ultra-low rates papered over. The accumulation of debt in the corporate sector is more worrisome this time around than the rise in household debt. The high-yield market looks particularly precarious.


A more disorderly and abrupt seizure in credit markets cannot be ruled out. No one knows how far the reach for yield and exposure to rate hikes many investors currently face.

That would represent a nightmare scenario for the Fed. Officials wouldn’t stand idly by and let a fully-fledged credit crunch gut the overall economy. That would mean a rapid, about-face on rates and could include a new round of quantitative easing. That could inadvertently force the Fed to repeat the mistakes of the 1970s and stoke a longer bout of inflation or stagflation.

Bottom Line

I will end where I began. The Fed is reluctant to say it must trigger a recession to derail the inflation we are enduring. Officials also won’t rule it out. Powell himself has admitted that the path to a soft landing is “narrowing” and is likely to “narrow further.”

This is Powell’s Paul Volcker moment. He is looking to break the back of inflation as the former Fed chair did in the 1980s. A further slowdown is “necessary” to reestablish an anchor for inflation expectations and head off a more vicious stagflation cycle. That includes a “softening in labor market conditions” or a rise in the unemployment rate. The magnitude the Fed is mulling equates to a mild recession.

Rate hikes are a crude tool. They lack the precision to land the economy without hitting some potholes.

When I was a kid, my family would cross the Canadian border to see geese gather as they migrated south for the winter. It is not the 1970s and geese are not ducks, but the two are similar. Hoping we can avoid the chill of winter when the geese are already in the process of migrating seems fanciful.


Economic Forecast – August 2022

National Outlook
Chain Weight GDP15.

Personal Consumption

Business Fixed Investment


Residential Investment


Inventory Investment (bil $ '12)


Net Exports (bil $ '12)




Government Expenditures




State and Local
Final Sales5.

GDP Deflator


Core CPI
Special Indicators

Corporate Profits2


Disposable Personal Income


Housing Starts (mil )


Civilian Unemployment Rate

Total Nonfarm Payrolls (thous)3

Vehicle Sales

Automobile Sales (mil )



LtTrucks (mil )




Combined Auto/Lt Truck


Heavy Truck Sales
Total Vehicles (mil )14.814.415.013.714.714.014.114.714.815.215.114.8
Interest Rate/Yields

Federal Funds

10 Year Treasury Note

Corporate Bond BAA
Exchange Rates


  1. in 2021, GDP was $19.4 trillion in chain-weighted 2012 dollars.
  2. Corporate profits before tax with inventory valuation and capital consumption adjustments, quarterly data represents four-quarter percent change.
  3. Total nonfarm payrolls, quarterly data represents the difference in the average from the previous period. Annual data represents 4Q to 4Q change.
    Quarterly data are seasonally adjusted at an annual rate. Unless otherwise specified, $ figures reflect adjustment for inflation. Total may not add up due to rounding.

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Meet our team

Image of Diane C. Swonk
Diane C. Swonk
Chief Economist, KPMG US

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