The Big Idea
Economy Outlook 2022: Surprises from growth, labor, inflation and the Fed
Stephen Stanley | November 19, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The consensus economic forecast for 2022 is conservatively optimistic. The most recent monthly Bloomberg survey of economists has median real GDP growth forecast at about 4% in the first half of the year, slowing to around 3% in the second. The unemployment rate falls, reaching 4% in June and inching down to 3.8% by year-end. And inflation still largely looks transitory, with year-over-year advances in the PCE headline landing at 2.3% in December and PCE core at 2.5%, outcomes the Fed would undoubtedly gladly take. While financial markets in recent months have started to price in at least two Fed rate hikes next year, the majority of economists in the Bloomberg survey this month for the first time projected liftoff before the end of next year. Relative to that consensus, there are a few key risks: the economy overheats, labor shortages persist, inflation stays elevated, and the Fed plays catch-up.
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Economy continues to overheat
One of the biggest surprises of 2021 was the extent and the persistence of supply bottlenecks. The unwinding of these snags in the supply chain proved elusive. Still, there is broad agreement they will abate in 2022. While I do not entirely disagree, I would offer a more nuanced assessment.
Some of the kinks in the supply chain are purely related to production issues and are likely to be resolved in 2022. The best example would be the chip shortage that has plagued automakers for more than a year. Supply was hit by several discrete events this year, including a fire at a chip factory in Japan and the cold snap in Texas last winter that took several chip plants offline for an extended period. As 2021 draws to a close, chip supplies are beginning to pick up and auto assemblies are finally creeping higher.
Not all of the supply bottlenecks are likely to be resolved so easily in 2022. That is because many of the so-called supply bottlenecks are more accurately a reflection of an overheating economy. For example, the backups seen at West Coast ports over the past few months are not being caused by some specific physical problem associated with Covid. Rather, they are being driven primarily by an unprecedented demand for goods by retailers and wholesalers ahead of the holiday season. Sure, there is a shortage of truck drivers to transport goods from the ports and more broadly to their final destination. Some might argue that the driver shortage is a reflection of Covid-related labor market issues, but the level of payrolls for truck transportation in October was less than 10,000 lower than in February 2020, a decline of less than 0.5%. The bigger issue is that trucking firms need tens of thousands more drivers today to haul a much larger volume of goods that consumers and businesses want to buy, at least compared to before the pandemic.
I expect that consumer demand will remain elevated next year, driven by strong job gains, sharp wage hikes, and the unleashing of some portion of the trillions of dollars in excess savings piled up during the pandemic. Likewise, business demand should be propelled by robust profit growth. As a result, as supply issues associated with Covid recede in 2022, I would not be surprised to see the economy continue to struggle to meet elevated demand. In short, the economy may continue to overheat for much of 2022.
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Worker shortages persists
There is a clear analog in the labor market. The prevailing narrative is that the labor market is as tight as it has ever been mainly because so many potential workers are sitting on the sidelines, presumably due to health concerns related to Covid. That is undoubtedly true to an extent. However, as I laid out in a recent piece, the shortfall in labor force participation relative to the economy’s optimal level is probably not as large as it might appear at first glance.
Private sector payrolls were about 3.3 million lower in October 2021 than in February 2020. Much of that gap could be made up over the next several months, as people sitting out of the labor force due to some combination of generous government support, childcare worries, and health concerns filter back. Meanwhile, the demand for workers is extraordinary. The private sector job openings figure is 9.6 million, more than 3.3 million higher than in February 2020, a time when the labor market was already unusually tight.
In theory, if 2 million to 3 million people move off the sidelines and into a private sector job over the next, say, six months, then the labor force participation rate should be back to a level consistent with demographics. And, at something close to the current pace of descent, the unemployment rate will slide to the FOMC’s estimate of a full employment economy of 4.0% by early next year.
I believe that we will reach readings for employment, labor force participation, and unemployment in the first half of 2022 that would be broadly consistent with full employment. There is a risk that when we reach that point, there will still be a significant labor shortage, with elevated job openings and firms still desperately bidding up wages to try to staff up sufficiently to meet ebullient demand.
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Inflation moderates but stays elevated in 2022
In the summer and early fall of 2021, the debate on inflation was whether the run-up was strictly transitory, as most Fed officials argued, or would persist for a while. By now, that debate is largely settled. The hope of a brief and fleeting spurt in prices has been dashed. Inflation pressures have broadened behind the handful of pandemic reopening categories and intensified.
Heading into 2022, the central question as it relates to inflation is how much the pace of price hikes will moderate. As the consensus forecasts suggest, most economists expect inflation to slow sharply next year, almost all of the way back down to the Fed’s 2% target. I look for cooling as well but not by as much as the median forecast expects.
As noted above, some of the supply bottlenecks should abate in 2022, which should have beneficial implications for the inflation outlook. For example, as auto assemblies ramp up in the coming months, the pace of increases in new and used vehicle prices should abate. Indeed, motor vehicle prices could even recede in 2022.
However, demand for goods and services is likely to remain elevated in 2022, reflecting the stellar balance sheet positions and income gains of consumers and businesses. As long as demand is substantially stronger than normal, supply chain issues should persist.
Moreover, the longer households and firms deal with rapid price advances, the more acclimated they become. Inflation expectations have already moved higher, even at longer time horizons. Workers have a newfound militance for wage increases, as evidenced by a number of strikes in recent months. A wage-and-price spiral has not set in fully yet, but it is fair to say that inflation expectations are in danger of becoming unanchored.
I consider my inflation projections for 2022 to be quite optimistic. With headline PCE inflation likely to end this year at around 5.5% and core at 4.5%, a substantial deceleration is likely in 2022 even though the lingering effects of fiscal largesse will continue to be in play and monetary policy will remain quite easy, albeit finally in the process of normalizing. Even so, I expect both headline and core PCE inflation to remain above 3% on a year-over-year basis throughout 2022, well above consensus and the FOMC’s latest projections. Moreover, I would argue that, in light of how rapidly inflation has run up in 2021, the risks with respect to my inflation estimates for 2022 are mostly to the upside.
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The Fed plays catch up and a low neutral rate Is called into question
Sentiment on Fed policy for 2022 has shifted radically over the past six months. In early 2021, the consensus view was that tapering would be a 2022 or even 2023 story, and liftoff was considered to be a 2024 proposition. Now, however, asset purchases are expected to end by June at the latest while fed funds futures are pricing in close to 2.5 quarter-point rate hikes by the end of next year.
While the near-term monetary policy outlook has made the bulk of the adjustment that will likely be necessary, financial market participants still broadly expect the upcoming rate hike cycle to be quite limited by historical standards, looking much like the 2015-to-2018 experience rather than prior rate cycles. Eurodollar and SOFR futures suggest that investors expect Fed policy rates to peak below 2%, even though the FOMC’s own estimate of the long-run neutral funds rate is 2.50%. This helps to explain the fact that long-term Treasury yields remain so low by historical standards.
If my economic projections for 2022 are correct, with economic growth remaining well above trend, the labor market tightening, and inflation remaining far above the FOMC’s target, even as the funds rate begins to rise in the second half of the year—with quarter-point hikes in June, September, and December—then there is a risk that financial market participants will need to revisit their assumptions of a historically low terminal rate for the upcoming rate hike cycle. If the Fed is far behind the curve, as I believe, then policy is likely to have to move to restrictive territory over the next several years to tamp down inflation, a scenario that is not currently priced into markets and indeed has arguably not even been seen in this century.