Notes on the Economy – Q2 2022 Summary

HITTING A POTHOLE

The U.S. economy hit a technical pothole in the first quarter of 2022; real GDP fell an annualized 1.4%. Fortunately, the wheels were not knocked off the economic machine. As the effects of the COVID-19 Delta variant waned in late 2021, rebounding demand and inventory restocking drove real GDP up 6.9% in the fourth quarter, just as the Omicron variant made landfall. However, Omicron was not the root cause of the subsequent downturn in real GDP. Rather, unrelated relative weakness in net exports, inventory investment, and government purchases drove the change in real GDP into negative territory. Private domestic final demand for goods and services remained quite robust, advancing 3.7%, versus 2.6% in the fourth quarter of 2021.

Demand for output is on a strong growth track, but that does not mean all is rosy. Some parts of the economy are running too hot. The unemployment rate is only 3.6%, and there are nearly twice as many unfilled job openings as there are unemployed persons. Annual consumer price inflation is running at 8.3%, exacerbated by still-lingering pandemic-induced disruptions in global supply chains and newly induced actual and threatened shortages in commodity markets due to the Russo-Ukraine War.

It is not just the United States that faces tight labor markets and soaring inflation—the phenomenon is global. As a result, the Federal Reserve (Fed) and many other central banks have initiated a shift to tighter monetary policies, raising interest rates and paring the size of their securities portfolios.

HEADLINES – WHAT’S IMPORTANT

• External Threats to the Economy Are Serious –COVID-19 is not gone; the Omicron variant has already spawned five identified subvariants, each more infectious than the previous. Russo-Ukraine War developments could hinder the rectification of global supply chain issues, or even make them more acute.
• The Fed’s Policy Shift Has Increased Recession Risk – Fed policymakers appear uniform in their determination to stop inflation through tighter financial conditions. The probability of overdoing it has risen.
• Bonds Are Not Bargains – Monetary tightening has been priced into the market, but duration risk remains elevated and could have adverse consequences if yield increases persist.
•  Lower Equities Prices Do Not Offer Much Solace for Investors – The broad equities market has already breached the average downside for a non-recession bear, but investor caution is still warranted. Operating and interest rate risks have gone up, while the “Fed put” has been withdrawn.

 LOOKING AHEAD

Although the risks to the economy noted above are real, the most adverse possible developments are not the most likely. Omicron subvariants are becoming more contagious, but not more severe. The intensity of supply chain disruptions from outside the zone of the Russo-Ukraine conflict have started to wane, and war-related disruptions have largely been priced into commodities. The Fed’s initial tightening moves are likely to be swift only to the point of neutrality.

Underlying economic trends suggest near-term growth prospects for the U.S. economy are solid. For example, unemployment remains low, and job growth is strong, as are consumer spending and new capital goods orders. Also, it is apparent that the composition of economic output has started to shift back toward pre-pandemic norms with a growing proportion tilting toward services and away from goods. The Institute for Supply Management’s Purchasing Managers Indices (PMI) for April show manufacturing and services readings of 55.4 and 57.1, respectively. A reading of more than 50 is in expansion territory. Inventories will be a drag on growth but, even accounting for the negative first quarter, full year-over-year growth of real GDP for 2022 should reach 2.5%.

Global economic growth has become more subdued as a result of the widespread acceleration of inflation and the contra-inflation policies underway or likely to soon be taken by the authorities around the globe. The International Monetary Fund (IMF) downgraded its 2022 projection for global real GDP from 4.4% in January to 3.6% in April. The growth outlook was cut by 0.6 percentage points to 3.3% for the advanced economies and by a full percentage point to 3.8% for the emerging market and developing economies.

* The information contained within this edition of the Notes on the Economy Executive Summary is based on data released as of May 18, 2022.

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