The US economy has been substantially hit by the Covid-19 pandemic over the last two years with 2020’s lockdowns leading to a nosedive in economic activity followed by sharp rebounds on reopening amid unprecedented policy support.
Meanwhile, increases in demand coupled with seized-up supply chains have led to the highest inflation rates in a generation. How can the US economy find balance again?
In new research from Wells Fargo Securities, economists Jay Bryson, Mark Vitner, Nick Bennenbroek and Tim Quinlan take a look at what could be in store for the American economy.
Signs of balance
Wells Fargo sees “tentative signs” that balance is starting to be restored, at least on the demand side of the economy. Since many parts of the service economy was more or less shut down during the pandemic, consumer spending on goods became supercharged; the level of US retail sales currently stands about 21% above its pre-pandemic peak.
During the previous economic cycle, it took almost nine years for retail spending to rise by a similar amount above the previous peak. But real spending on durable goods, which was pulled significantly forward, has declined by more than 9% on balance since its peak in March of this year.
Meanwhile, real spending on services, which usually accounts for about two-thirds of consumer spending, continues to make steady gains.
Labour market balance
One part of the economy where imbalances are most pronounced is the labour market. The share of businesses reporting that good help is “hard to find” has hit a record and so has the share of consumers saying that jobs are plentiful.
“This is the tightest labour market in at least a generation. Perhaps this should not be much of a surprise, given how the Great Resignation is only picking up steam; the quit rate rose to a fresh high of 3.0% in September,” the economists said.
While lower-paying industries such as hospitality, transportation and warehousing have seen the largest wage increases over the past year, higher-paying industries have recently begun seeing stronger pay hikes as well.
More people working along with higher wages for everyone is pushing aggregate income to new highs, with labour income rising at a three-month annualised rate of nearly 12% in November, still comfortably ahead of inflation.
The biggest headwind for employment is the difficulty businesses have finding good help. While workers are making their way back into the hiring pool, finding a better balance may take until next spring
“Constraints such as health concerns and child care should ease on the other side of winter, and the further households get from the generous fiscal policy support enjoyed over the past year, the greater the financial imperative to return to work should be – not to mention inflation chipping away at spending power,” the Wells Fargo economists said.
These factors should help hiring continue at a robust pace and reduce the unemployment rate to its pre-Covid level near the end of 2022.
Goods inflation has been the primary contributor to the historically high inflation experienced this year. With most car dealers still struggling to get inventory on their lots, vehicle prices have kept significant upward pressure on price growth but that is far from the only driver.
Prices for other goods, such as home furnishings, recreational items, food and energy have experienced the largest one-year jumps in at least a decade.
“We suspect it will take more time for the supply-demand imbalance, and by extension price growth, to normalize,” Wells Fargo’s economists said.
It is not just further strength in the price of goods leading economists to believe that inflation will remain an issue for households, businesses and policymakers in 2022. Services inflation has been tamer in 2021 but is gaining momentum.
The shelter component – which accounts for nearly one-third of the CPI – has started to surge as the lagging effect from higher home prices and rents works its way into the CPI.
“With hotels finally seeing occupancy pick up, lodging away from home is starting to see larger price increases. Similar trends could be in the offing for airfare as travel returns to something reminiscent of normal after some Delta-related weakness in these categories over the summer,” the economists said.
Wells Fargo expects inflation to get worse before it gets better, particularly over the next few months. Coupled with strengthening services inflation, the firm suspects that the overall rate of CPI inflation will average 7% in the first quarter of 2022.
“We believe that inflation will continue to be an issue for the US economy through much of 2022, and we forecast that the overall rate of US CPI inflation will average 5.3% next year, which is markedly higher than the consensus forecast.”
But restoring balance in the American economy will not happen overnight due to the outsized imbalances that developed.
“We project that real GDP grew at a blistering pace of 5.7% this year, which would be the strongest year of economic growth since 1984. Looking forward, we forecast that real GDP growth will downshift to about 4.4% in 2022, which is still an above-trend rate of growth,” the Wells Fargo economists said.
However, supply chains remain clogged, and they likely will not be restored to “normal” any time soon. The recent emergence of the Omicron variant clouds the outlook, but Wells Fargo does not believe it will lead to the broad lockdowns seen in the early days of the pandemic as they believe there seems to be little public support for the return of restrictions.
Inflation continues to run hotter than most US Federal Reserve rate-setting committee members had previously expected, so Wells Fargo is looking for the Federal Open Market Committee (FOMC) to increase the pace of its monthly taper.
Wells Fargo is looking for the Fed to reduce its monthly pace of asset purchases by $22.5bn (£17bn) each month beginning in January. If the Fed continues this pace of reduction in coming months, then it would stop purchasing assets in April, giving it the option to begin hiking rates at that time.
“Although monetary policy tightening will not unclog supply chains, it can help ensure that inflationary expectations, which could lead to even higher inflation in coming years, do not become unmoored,” Wells Fargo’s economists said.
The firm forecasts that the rate-setting FOMC will hike rates by a cumulative 50 basis points in the second half of 2022 followed by 75 basis points of more tightening over the course of 2023.