Economy Commentary

Meet The New Year, Same As The Old Year?

January 2022

It may be a new year, but it kind of doesn’t feel that much different than the last one. After all, 2021 started with consumers, businesses, and governments responding to a surge in COVID cases, and that is again the case as 2022 gets underway. Clearly, the pandemic, its impacts on consumers and businesses, and the policy responses to it were the main storylines of the U.S. and global economies in both 2020 and 2021 and, at this point, there seems little reason to believe 2022 will prove to be any different. Still, whether it feels that way or not, the calendar says it’s a new year, which means it’s time for us to look ahead at how we see the economy faring in 2022 though, admittedly, our outlook comes shrouded in a thick layer of uncertainty.

After what we expect will be full-year 2021 real GDP growth of 5.6 percent, our baseline forecast anticipates real GDP growth of 4.1 percent in 2022. As in 2020 and 2021, intra-year growth patterns in 2022 will be shaped by the course of the pandemic. The current surge in case counts is weighing on economic activity, though with very little January data at our disposal as of this writing, it is hard to quantify the effects. Still, our January baseline forecast anticipates significantly slower Q1 2022 real GDP growth than was the case in our December 2021 baseline forecast. What isn’t clear to us is whether shifts in economic activity in response to rising, then falling, case counts will be the same, in terms of magnitude and timing, going forward as has been the case thus far. This is just one of many sources of uncertainty around our 2022 outlook.

As 2021 was coming to a close, there were signs that global supply chain and logistics bottlenecks were beginning to ease, and we expect further improvement as we move through 2022, with further easing of remaining constraints supporting stepped-up manufacturing activity. To that point, nonfarm business inventories were drawn down significantly over the course of 2021, and we anticipate restocking will be a meaningful tailwind for growth in 2022. Additionally, with production having been curtailed in 2021, manufacturers and homebuilders ended the year with sizable backlogs of unfilled orders and, with supply-side constraints easing, backfilling these orders will also be a tailwind for growth in 2022.

As the supply side of the economy normalizes further over the course of 2022, the demand side is being weaned from the considerable fiscal and monetary support seen in 2020 and 2021. Still, though to a lesser degree than was the case over the prior two years, fiscal policy and monetary policy will remain accommodative in 2022. With continued robust growth in labor earnings, a significant pool of excess saving, and healthy household balance sheets, there are plenty of supports for continued growth in consumer spending, though elevated inflation will likely weigh on growth in discretionary spending. With diminished affordability weighing on growth in demand and inventory constraints gradually easing, the pace of house price appreciation will slow, but we nonetheless expect double-digit growth in 2022.

If we are correct in expecting further easing of supply chain and logistics bottlenecks, that would contribute to a sharp deceleration in goods price inflation, if not outright goods price deflation. While that would act as a drag on overall inflation, we nonetheless expect faster growth in services prices, including rent and medical care, and continued robust growth in labor costs to keep inflation easily above the FOMC’s 2.0 percent target rate through 2022. While we believe the FOMC will begin raising the Fed funds rate by mid-year, we also believe that the changing composition of the FOMC, including three new members of the Board of Governors, will act as a brake on the extent to which the funds rate rises during this cycle. It also seems likely that the FOMC will allow the Fed’s balance sheet to begin winding down not too long after their monthly asset purchases come to an end in March. This would be a significant departure from the FOMC’s playbook during the prior cycle, when the Fed’s balance sheet was held steady for nearly three years after the asset purchases ended.

To be sure, the outlook we’ve outlined above seems too nice and neat in a world that, in case anyone still hasn’t caught on, is seldom so. That raises the question of what could go wrong. At the risk of stating the obvious, the primary risk to the U.S. and global economies in 2022 remains the COVID-19 virus. To the extent global manufacturing and shipping hubs are subject to further spikes in case counts, any progress made in clearing supply chain/logistics bottlenecks could be quickly reversed, weighing on economic growth and keeping upward pressure on goods prices. It would seem foolish to presume that there won’t be additional variants of the virus in the months (years?) ahead, meaning that how consumers, businesses, and governments respond is critical in determining the extent to which economic activity is disrupted.

While it seems clear that COVID-19 remains the biggest downside risk to our outlook, that doesn’t mean it is the only downside risk. For instance, we and most others expect inventory restocking to contribute to real GDP growth in 2022. At the same time, we also respect how quickly inventories can swing, to the point that what begins as a restocking of depleted inventories turns into an inventory overhang, particularly when, as at present, businesses are unsure of the true level of demand. It is reasonable to wonder whether demand for goods is due for a “correction,” given the extent to which pandemic-related transfer payments coupled with restrictions on many segments of the services sector juiced consumer spending on goods. Not knowing the true level of demand makes it difficult for firms to correctly gauge the appropriate level of inventories. If inventories become too swollen, that could quickly lead to sharp cuts in output and employment which, if of sufficient magnitude, could trigger a recession.

Additionally, should inflation prove to be more persistent than our baseline forecast anticipates, that could trigger a sharp decline in discretionary consumer spending, and could also trigger a sharp increase in market interest rates that would weigh on activity in interest-sensitive segments of the economy. We also worry that with the high level of debt in the non-financial corporate sector, particularly amongst companies at the lowest “investment grade” rating level, sharply higher interest rates and slowing economic activity could trigger payment stresses that could weigh heavily on business investment spending. Finally, the combination of elevated inflation and the FOMC moving to lessen the degree of monetary accommodation opens the door for a policy mistake, real or perceived, triggering swings in market interest rates that would impact the broader economy.

Source: Bureau of Economic Analysis; Bureau of Labor Statistics; Federal Reserve; Institute for Supply Management


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