Outlook 2022: US – Structural realignment to ease pricing pressures

Key points

• Supply chain pressures should ease if COVID is brought under control. Inflation is on track for a 40-year high, with a peak expected in end-2021, then a material fall from Q2 2022
• GDP growth should continue at a robust pace, though likely decelerate. We forecast growth of 5.5% in 2021, 3.5% in 2022 and 2.7% in 2023
• The Federal Reserve looks set to start a material tightening cycle at the end of 2022. Doubts about managing longer-term inflation risk an earlier start

Supply constraints and inflation

The rapid rebound in demand across 2021 gave rise to severe bottlenecks in the supply chain. This has been evident in markets like lumber and iron ore, where prices have surged and then fallen. More persistent shortages – including in semiconductors – look set to remain into H2 2022. More recently, global natural gas demand has provided an indirect boost to gasoline prices, which have risen further. This rolling series of supply shocks has contributed to rising prices. We expect supply restrictions to ease in 2022, both as supply adapts – particularly if emerging markets better contain COVID-19 – and as consumer demand reverts towards services, easing demand for durables (Exhibit 1), again assuming domestic virus concerns abate.

Exhibit 1: Unwinding the consumer goods binge

Source: Bureau of Labor Statistics (BLS), AXA IM Research, November 2021

The impact on inflation has been stark and more extreme than we had expected. CPI inflation rose to 6.2% in October – a 30-year high, and well above 2008’s 5.6% peak. With increases in second-hand autos, airfares and particularly rents set to persist, the outlook is for inflation to peak below 7% in December. This sees us revise our near-term forecasts further to average 4.7% in 2021 and 4.1% in 2022. Yet a series of price-level adjustments must surely end with inflation attenuating and then reversing sharply. This appears likely from Q2 next year and should be compounded by a now-softer growth outlook, with price increases eroding consumer spending power. Inflation should only be self-sustaining if household incomes can continue to grow, which is why markets reacted to signs of sharp wage growth in Q3 2021. We continue to forecast CPI inflation falling back sharply in 2022 to average 2.9% in 2023, consistent with the Federal Reserve (Fed)’s Personal Consumption Expenditure inflation target at 2.5%.

Fiscal spend, excess saving and growth

The bipartisan infrastructure bill, adding $550bn (2.4% of GDP) in new money, was a key milestone, but should be joined by a further $1.6tn (6.5% of GDP) bill, boosting growth in the coming years. Even so, previous packages have been larger, with a combined spend of 12% of GDP in March/April 2020, 4% in December 2020 and 9% in March 2021. Moreover, these latest packages include revenue raising measures – that are expected to raise around $1.5tn. The net fiscal stance should tighten to -5% of GDP next year.

This appears a significant headwind to growth. Yet previous fiscal support included direct transfers to households, a large proportion of which still exists as excess saving – estimated to be around $2.25tn (9.7% of GDP). This would be sufficient to cushion the drop in government spending. However, these savings are not evenly distributed. The Fed estimates that around two-thirds are held by households in the top 20% of incomes, and the remaining third by the bottom 80%. For the latter group, we expect savings to be a useful buffer against the expected income squeeze. However, the top income deciles are more likely to treat this as wealth – spending relatively little. Excess savings should fall but are unlikely to fully cushion the economy.

Growth outlook

With supply pressures likely to persist through H1 2022 and inflation elevated, we expect pressure on income growth (and saving) to dampen activity. While excess saving should provide a buffer, a broad-based employment recovery should bolster labour income next year. We expect US GDP to grow by 5.5% in 2021, then decelerate to 3.5% in 2022 – softer than the consensus view of 4% – and 2.7% in 2023 (2.4% consensus). We forecast that supply constraints will dampen growth relative to expectations over the next few quarters, but an easing of constraints, and a rebuild of inventory, should underpin firmer growth beginning in H2 2022.

Labour market and longer-term inflation outlook

The labour market should enjoy rapid job growth. We estimate an average monthly payroll increase of 350k across 2022 – with pent-up demand suggesting upside risk. This will drive unemployment lower, but how quickly will depend on labour supply. Weak labour supply growth – flat on average over the past 12 months – exaggerated the fall in unemployment in 2021, down over 2ppt to 4.6% in October from December 2020’s 6.7%. In 2022, we expect labour supply to rise, dampening the fall in unemployment.

This should include an increase in labour force participation. Participation rose to 61.7% in August 2020 but has not improved since. Exhibit 2 shows that some of this decline (0.4ppt) is attributable to older workers (55 years old plus) having left the workforce. These may have retired permanently. Yet the bulk of the drop is from workers aged 16 to 55, primarily female. Difficulties around caregiving and healthcare appear to account for this withdrawal. If COVID-19 continues to fade across 2022, it should facilitate a return of these prime age workers. Moreover, a return of some workers is also likely (already adding 0.2ppt above H1 2021). We expect participation to recover significantly next year.

Exhibit 2: Most of labour force drop temporary

Source: BLS, AXA IM Research, November 2021

A recovery in labour supply would have a key impact on the medium-term inflation outlook. A shortage of labour supply contributed to Q3’s 20-year record increase. Rising supply should help meet the significant labour demand and cool wage and unit labour cost growth – key drivers of core inflation. By contrast, if labour supply remains subdued, the risk of more persistent inflation will emerge.

Federal Reserve – holding the line

The Fed is committed to reducing its asset purchases by $10bn in US Treasuries and $5bn in mortgage-backed securities per month for the rest of 2021. It then suggests a similar pace in H1 2022, to end asset purchases by mid-2022. After this it will consider raising the Fed Funds Rate (FFR), subject to its forward guidance conditions that inflation is 2% and expected to be modestly in excess of that over the coming years, and that the labour market should be “consistent with full employment”.

Yet the Fed is not clear what full employment will look like. Uncertainties around permanent shifts in the labour force question what level of unemployment or labour force participation is consistent with full employment. When change occurs on both demand and supply sides, price developments become important. The Fed will watch wage growth as the key barometer of labour market capacity.

The Fed may also have to act in the face of rising inflation. Emerging market central banks typically respond to transitory price shocks because inflation expectations are not well-anchored. Developed economy central banks tend to have the luxury of “looking through” such shocks. With inflation elevated for a prolonged period, many see the ‘transitory’ explanation as stretching credulity. The market currently considers three FFR hikes in 2022 to reinforce its credibility.

We still expect inflation to retrace sharply from Q2 next year and the labour market to heal more slowly than the Fed considers. As such, we forecast the Fed leaving policy unchanged until end-2022. However, we then expect a full tightening cycle to lift rates to 1.001.25% by end-2023 and continue through 2024. If inflation expectations rise further, the Fed may have to begin a tightening cycle sooner.

A pivotal phase for US politics

The US holds midterm elections in November 2022. Recent elections in Virginia and New Jersey delivered significant Republican swings, beating the incumbent Democrat in Virginia, which had voted solidly for President Joe Biden last year. Such a swing is consistent with downbeat Presidential approval ratings, which group Biden with other Presidents that have gone on to lose control of Congress in midterms, than those who have held on to majorities¹ .

President Biden no doubt hopes that the delivery of major infrastructure deals will change the mood of the nation. Perhaps more importantly, an improvement in economic conditions, including significant job gains and a retracement from exceptional levels of inflation, will improve the public perception. However, with tight margins in both Houses of Congress, the outlook appears for a loss of both majorities in November. This would deliver political gridlock. In economic terms, this may not alter the outlook much, with the rollout of recent spending bills still to dominate. But it would set the stage for a potentially era-defining 2024 Presidential election.