Recap: The new year started with a bang. First, a rapid increase in COVID-19 cases began quickly dwarfing all previous waves. Fortunately, hospitalization rates did not rise as swiftly, but still ticked up at the same time that healthcare capacity was constrained by staffing shortages. With worker shortages already a pressing issue, the current wave is likely to weigh on near-term business performance and slow the recovery in high-personal contact services.
Second, adding to business challenges, workers were quitting their jobs at record rates, while job openings remained near all-time highs. Employers continued to add jobs, 199,000 in December. The unemployment rate also fell from 4.1% to 3.9%, aiming for its pre-pandemic level of 3.5%. With high demand for workers and increasingly limited supply, it is little surprise that wage growth remains hot.
Third, on the production side, there was some good news on easing supply constraints. The ISM manufacturing index slipped to 58.7 in December from 61.1 in November. Despite the slip, manufacturing activity is still expanding at a healthy clip. More encouragingly, there were hints that supply-chain problems could be easing as the supplier delivery sub-index fell. The decline suggests that delivery times are improving, which is a relief given the severe bottlenecks that manufacturers have been facing. There was also a pullback in the ISM services index to 62 from 69.1 in November. The service sector also saw improvement in supplier delivery times as the index fell by 11.8 percentage points to 63.9 – the lowest reading in the past eight months.
Finally, U.S. retail spending and manufacturing slowed at the end of 2021 as the Covid-19 Omicron variant and inflation surged, early signs the latest complications from the pandemic could be weighing on the economy. U.S. retail sales dropped by 1.9% in December, damping the end of the holiday shopping season. The decline suggests that consumers, faced with rising prices, are normalizing their spending. This may also be the result of shoppers front-loading their purchases in the wake of supply chain challenges and reports of holiday shortages.
U.S. industrial production fell for the first time since September. Industrial production unexpectedly fell 0.1% in December despite indications that wait times are shortening and other signs of initial improvement with the supply chain problem. A surge in mining output prevented an even larger decline. Manufacturing output, a key component of the reading, dropped 0.3% as supply-chain issues continue to affect output.
Inflation: U.S. inflation hit its fastest pace in nearly four decades last year as pandemic-related supply and demand imbalances, along with stimulus intended to shore up the economy, pushed consumer prices up. The consumer-price index rose 7% in December from the same month a year ago, the fastest pace since 1982, and marked the third straight month in which inflation exceeded 6%. Consumer prices were up a solid 0.5% month-over-month (m/m) in December. The core price index climbed 5.5% in December from a year earlier. Core inflation is likely to get even higher in the first quarter of 2022 on a year-over-year basis as price levels are compared to the relative weakness in early 2021.
Inflation is expected to ease this year as supply bottlenecks clear and demand normalizes, but the Omicron variant of Covid-19 has renewed uncertainty about the economic outlook as the pandemic continues. The smaller U.S. labor force can also be an issue going forward for inflation, more so than these supply-chain issues. The December employment report signaled a continued tightening of the job market and the resulting increase in wages. Wage increases are contributing increasingly to high inflation because they support higher spending, but also because they raise costs for businesses.
Labor Market: U.S. hiring slowed in December to 199,000 new jobs, though the U.S. added a record number of positions in 2021. The unemployment rate fell to 3.9% last month from 4.2% in November, as 170,000 people joined the workforce. But the nation remains 3.6 million jobs short of pre-pandemic levels.
Businesses and workers are gradually learning to live with successive waves of the coronavirus pandemic, limiting economic damage. Still, Omicron threatens to temporarily dent the economy by sending millions of sick workers into quarantine, exacerbating labor shortages. Employee absences will hurt production and slow services without leading to widespread layoffs.
Housing: Housing has been one of the bright spots in the broader economy in 2021. Buyers have been motivated by low-interest rates, higher household savings, and a desire for more space to work from home. Demand also has been fueled by a large wave of millennials aging into their prime home-buying years. Meanwhile, the supply of homes for sale has stayed well below normal in 2021. Home prices have soared as buyers have competed for a limited number of homes. With the Federal Reserve on course to raise short-term interest rates this year, mortgage rates are likely to accompany them higher, making home affordability an even greater challenge. Demand is likely to stay strong in 2022. People who are looking to buy a home but moved to the sidelines out of frustration are poised to return to the market if there is any sign of opportunity.
Monetary Policy: The strength in the labor market, combined with more persistent inflationary pressures has added urgency to the Federal Reserve's task of curtailing pandemic-induced support measures. This culminated in the Fed's decision to speed up the taper of their Quantitative Easing program and possibly faster pace of rate increases.
At least three interest rate hikes are expected in March, June, and September with the FOMC raising rates by 25 bps at the March 16 policy meeting.
The Fed will also start shrinking the size of its $8.8 trillion balance sheet. The Fed most likely will allow a passive runoff of the balance sheet, by allowing some of the proceeds from its maturing bonds to roll off each month while reinvesting the rest. This shrinking in the Fed's balance sheet should contribute to the upward creep in yields on longer-dated Treasury securities and mortgage rates.
Fiscal Policy: Federal fiscal policy developments were a key driver of the U.S. economic outlook in 2021, but as 2022 begins, fiscal policy has quietly taken a back seat. Most of the pandemic-related fiscal policy support has run its course, and Democrats' Build Back Better plan appears unlikely to become law anytime soon. Congress increased the debt ceiling in December by $2.5 trillion, which should give enough borrowing room to last through all of 2022.
U.S. Dollar: In something of a surprise, the U.S. dollar has weakened over the first few weeks of this year and emerging market currencies have outperformed. A sharp shift in monetary policy stance from the Fed supported the dollar late last year but has done little to help the dollar so far in 2022; however, once the markets focus on underlying fundamentals, the U.S. dollar should strengthen against most G10 and emerging market currencies. The Fed has already sped up the tapering of its bond purchases, and with interest rate hikes now seemingly imminent, capital flows toward the U.S. dollar are expected to materialize over this year.
Emerging market currencies are expected to come under the most pressure in 2022-2023 as tighter Fed policy, higher bond yields, and local political developments result in weaker currencies across the emerging markets spectrum.
Eurozone: Mixed economic news from the Eurozone remains consistent with an outlook for only a gradual shift by the European Central Bank (ECB) toward less accommodative monetary policy. The December consumer price index (CPI) offered the first hints that Eurozone inflation may be nearing a peak. The overall CPI rose 5.0% year-over-year, though still only edging slightly higher from the 4.9% increase seen in November. There were hints that some underlying measures of inflation were starting to turn lower. While inflation remains well above the ECB's 2% inflation target, for now, the central bank forecasts a deceleration of inflation throughout 2022. Should that slowing of inflation progress as expected, that would support the outlook for only a gradual tapering of the ECB's bond purchases.
Other economic indicators are pointing to a probable slowing in economic growth in the fourth quarter of 2021 relative to that seen in the previous two quarters. For the October-November period, Eurozone retail sales are up 1.0% compared to their average level in Q3. However, given the spread of COVID cases in recent weeks and likely reduction in mobility, much slower growth or even an outright decline in sales for December seems likely. Indeed, Eurozone December economic confidence pointed to some loss of momentum. Economic confidence fell in December relative to November. Industrial confidence rose but services confidence fell quite sharply.
Outlook: The U.S. economy closed out 2021 on a high note. Real GDP growth in the year as a whole is expected to record a stimulus-driven 5.5% growth rate, which is expected to slow to 4.0% in 2022. Even so, this "slower" growth rate is still overshooting potential GDP growth, resulting in an economy that will be pressing deeper into excess demand territory. With the re-opening boost in the rear-view mirror, higher interest rates will likely reign in demand and temper annual average real GDP growth to 2.5% in 2023.
Inflation is likely to remain elevated throughout 2022, but slow from its peak at the end of 2021. Falling energy prices will take some wind from the headline growth rate over this year, but with a tight labor market, core inflation will remain above the 2% mark through the year.
U.S. employers added a record number of jobs in 2021, as a gauge of layoffs fell to a half-century low and open positions surged, but the pace of the labor market's strong recovery could slow in early 2022 due to the uncertainty posed by the Omicron variant of Covid-19. Jobless claims data will be closely watched in the coming weeks for any signs that the Omicron variant is causing employers to lay off workers.
Another constraint on employment and economic growth in 2022 could be the smaller labor force, which has 2.5 million fewer workers than before the pandemic. That has left employers clamoring for workers, raising pay, and sweetening bonuses and benefits—and in some cases looking to different types of workers than they have in the past. Labor supply constraints and the evolving pandemic, however, are unlikely to derail labor market improvements in 2022. With the economy going strong the demand for workers will also remain strong.
The Federal Reserve is likely to speed up the taper of its asset purchases and end-all net new purchases by the end of March 2022. This opens the door for an interest rate hike in March 2022. At that point, the Fed is expected to continue its rate hiking cycle with at least two more hikes in 2022. Expectations for rising policy rates, the end of Quantitative Easing (QE) by the Fed, and elevated inflation should push up government bond yields. This is already evident at the shorter end of the curve but is likely to show up in higher 10-year rates in the quarters ahead.
Global economic growth is expected to be around 5.5% for 2021. Growth in 2022 will likely slow to around 4.5% as supply chains have struggled under the pressure of intermittent shutdowns and ongoing input shortages. As new variants of the virus emerge, countries with low vaccine coverage present risks to interconnected supply chains. Given the resiliency of demand, and ample vaccine supply, the main downside risk to continued expansion is growing inflationary pressures and capacity constraints due to supply interruptions. One such risk comes from China's aggressive approach to containing COVID-19 outbreaks. Strict containment measures delay delivery of goods to end-consumers, increasing logjams and prolonging delivery times. Moreover, China presents a unique risk to the outlook into 2022 as it contends with an ongoing slowdown in its property sector and regulatory changes. The Chinese authorities are expected to mobilize stimulus in 2022 to achieve a GDP growth target between 5.0% and 5.5%.
Covid case counts are skyrocketing in the United States due to the increased spread of the highly transmissible Omicron variant, although the Delta variant continues to circulate as well. Fortunately, vaccines, a growing armament of therapeutics, increased immunity, and the less intrinsic virulence of Omicron appears to be widening the disconnect between cases and severe outcomes. That noted the Omicron surge represents a clear downside risk to the near-term outlook. Still, the Omicron surge looks to be having a milder effect on overall economic activity compared to earlier variants of the virus.
Sources: Department of Labor, Department of Commerce, Morningstar, Bloomberg, Standard & Poor's/Case-Shiller, European Commission, European Central Bank
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