About the author: Gregory Daco is the chief U.S. economist at Oxford Economics and former board director at the National Association of Business Economics.
The first phase of the Covid crisis was defined by a sudden stop in global economic activity of the kind that traditionally only occurs during wars. In phase two, the U.S. economy experienced a rebound that surpassed all expectations. From a 10% contraction in early 2020, real GDP rebounded above its prepandemic level in just one year on the back of unprecedented fiscal transfers to families, businesses, and state and local government.
What will phase three bring? The recovery in 2022 will be anything but a carbon copy of the two prior. Instead, it’ll consist of a delicate rebalancing act.
Think of a young child trying to balance a spoon on the edge of a glass. Push it a little too far to one side and it slips into the glass. Push it too far the other way and it falls out. That’s how the economy will feel in 2022. We’ll see consumers trying to adjust to an uncertain Covid backdrop and elevated prices. Business leaders will be constrained by tight supply and final demand uncertainty. Federal Reserve policymakers will be recalibrating monetary policy amid concerns about persistently elevated inflation, while lawmakers push for more fiscal stimulus with a razor-thin majority.
Stability will be hard to come by in 2022.
The recovery in consumer spending has been nothing short of extraordinary. Generous fiscal transfers in the form of expanded unemployment benefits, checks to families, and tax credits supported strong income growth as employment compensation gradually perked up. This led to a surge in spending on goods, rising about 10% above the pre-Covid trend, while spending on services remained 4.5% below trend. In 2022, stronger labor compensation and generally healthy household finances should support robust consumer outlays, but an unresolved health situation and Covid fatigue will continue to weigh on morale and spending intentions, especially over the winter. Higher prices and lingering delivery issues will also erode purchasing power and limit the upside to growth.
This will have direct implications for business managers that will have to contend with “MESSI” inflation dynamics—moderating expansion with sticky supply-driven inflation—where cost pressures persist and final demand uncertainty constrains their pricing power. With companies eager to protect profit margins, cost control will be key. But, the bullwhip effect will remain firmly in place—the phenomenon whereby each actor in the supply chain creates an additional contingency buffer. That will make small fine-tuning adjustments difficult to implement. Managers will look to preserve profit margins by controlling costs, but pressures on the labor and capital front will make this complicated. In that context, talent retention, productivity improvements, and market power will determine how strongly businesses emerge from 2022.
Private sector growth will be that much more important that the fiscal impulse will rapidly diminish. Following $5.5 trillion in near-term fiscal stimulus measures, Congress managed to pass the medium-term bipartisan Infrastructure and Investment Jobs Act providing an additional $550 billion in infrastructure outlays over the next decade. But, with Sen. Joe Manchin expressing his opposition to the $1.75 trillion Build Back Better bill, hopes of any additional fiscal stimulus before the midterm elections look slim.
The rebalancing of monetary policy will also require Fed Chair Jerome Powell to walk a tightrope. At its most recent policy meeting, the Federal Reserve crystalized a hawkish pivot amid rising inflation concerns. This pivot is aimed at repositioning the Fed to offer the optionality of tightening policy in 2022. But, just as crystal is fragile, this repositioning is not without risk. Indeed, Fed policymakers have succumbed to the view that labor supply constraints are structural, or at the very least long-lasting, thereby moving the maximum employment goalposts to justify a tighter policy stance. While financial conditions have not tightened excessively in the wake of this hawkish pivot, the Fed will need to be careful that a deteriorating health backdrop and excessive eagerness to tap the policy breaks could unnerve markets.
The rapid spread of the Omicron variant and the possibility of further Covid waves will make the economy’s rebalancing act ever more delicate in 2022, but consumers, businesses and policymakers have the tools and experience to avoid a tumble.
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