US Economic Outlook 2022
“Maybe there's a whole other universe where a square moon rises in the sky, and the stars laugh in cold voices, and some of the triangles have four sides, and some have five, and some have five raised to the fifth power of sides. In this universe there might grow roses which sing. Everything leads to everything.”
― Stephen King
When looking at the US economy at the start of a new year, it is impossible to ignore the feeling of staring at some kind of mirage, an otherworldly reality, a parallel world in an unconfirmed multiverse. In part it looks ever better than the last time I looked. In part, policy makers seem unconcerned about correcting the factor that risks destroying the outlook for a long time to come. The flegma of the Federal Reserve in addressing emerging inflation with the most suitable tool available - the Fed Funds policy rate - is inexplicable. Top-tier economist Willem Buiter writes extensively about this in his recent paper Why the Fed must tighten.
I usually write an Economic Outlook as a formal exercise in personal reflection, sometimes in the hope I will learn something from its publication, while certainly learning from the relative rigour of having to look at the data, analyze and interpret, and draw conclusions with some relevance to new ventures, supply of capital and funding costs. Invariably, I look at the parameters that are, or projected to be, out of range and ponder what that may mean for the overall outlook and the policy makers vested with powers to change the world.
Inflation
Writing from COVID quarantene I am well aware of the most conspicuous out-of-range parameter - the raging pandemic in its third year is impacting everyone, every nation, and every decision at a personal or national policy level. The perception of what the pandemic is, where it will go next and how it will impact decision-making is a wild card that keeps us guessing. The pandemic is largely credited with the return of inflation due to its extensive impact on the global supply chains, creating shortages and consequential bidding up of prices. Yet, it came at the heels of the US - China Trade Wars under the Trump presidency, and this has probably caused more havoc than first expected. I have continued to call inflation higher for the best part of the last year, also on the basis of the most recent release of the Personal Consumption Expenditures Price Index in December. For 2022, my estimate of PCE-PI inflation was raised from 6.3% to 8.0% just days ago. The long term normal range of US inflation is 1.1% to 3.3%, with the average value at 2.2%. Raising the policy rate is subject to at least a six-month lag before prices start responding. If we are already at 5.7% PCE-PI inflation as of November 2021, it will likely take at least a 2.5% hike to get back inside the normal range. Standard Fed models like the Taylor First Difference model laid out by Fischer during his recent term at the Fed, would now call for a 6.25% Fed Funds rate to bring inflation under control.
The Fed is regularly blamed for having triggered recessions by excessively hiking rates to pursue the price stability mandate, and so sacrificing the maximum employment mandate. The constraints on the Fed at any point in time can be estimated by the spread between the 10-year US Treasury yield and 0.3%, which is the UST-10 to Fed Funds rate spread limit, under which we are almost certain to head for a recession in about 5 quarters from first breach (yield curve flattening). At present, this maximum headroom for Fed policy rate hikes is 1.25%. This is totally insufficient for stopping 5.7% inflation from becoming 8% inflation at year-end. The Fed should nevertheless pull out the guns and raise Fed Funds to 1.25% this month in order to have any chance of inflation containment whatsoever.
The Fed is painfully aware of the inflation conundrum and being in trouble on their price stability mandate. They know they are forced to pursue alternative policies to contain prices, and they have already worked on the administration in one area - supply side policies. The release of a part of the US strategic petroleum stock pile had no appreciable effect at all on oil prices, but it was worth a shot. Price and wage controls are another tool, very poorly regarded in the community of economists, but when push comes to shove, you do whatever it takes to achieve the objective. Strong electrical vehicles incentives, including investments in charging infrastructure, will help at the margin to reduce demand for refined petroleum products. Energy efficiency programs for buildings and industry will similarly push back demand based price increases for energy.
One of the obvious possibilities the Fed has for creating headroom is to sell US Treasury bonds, of which they now own some 5.7 Trillion.
The only problem is to find buyers prepared to shell out enough money for moving the needle on such programs, knowing that the US Treasury will continue issuing bonds to fund Government programs.
The bottom line is that at 8% annual PCE-PI inflation this year, there are very few financial instruments that can deliver real returns on investment. There is little room for raising rates without slowing economic growth, and so hurting the maximum employment mandate of the Fed. At this rate of inflation, wages and interest on borrowings will add to raw materials and intermediate goods costs of enterprises to lower earnings. It is unlikely that the Fed will meet its price stability mandate this year and this will likely be an election campaign theme that could shift the power balance in Congress later in the year, causing the Biden Administration difficulties in completing programs and agendas.
What's next: US CPI inflation for December 2021 reported at 7.1% year-over-year in week of January 10.
Employment
The US labor force participation rate has been outside the long term normal range of 63.5% - 67.0% since Q3 2013. When unemployment figures are reported at the coveted Full Employment level of 4.2% or below, we have to consider that this percentage now is for a lower base labor force in absolute numbers. There are at least 4.9 million workers missing from the labor force as of December 2021, and so Unemployment will be reported at 6.5 million, rather than the more realistic 11.4 million. We have already seen this narrow unemployment measure reported at 4.1% on an unadjusted basis for two consecutive months and this week we will likely see the Employment Situation Report showing a further drop to 4.0%. Labor force participation is likely to drop from 61.8% in November to 61.6% in December 2021, which means that the participation adjusted unemployment level increases from 11.6% to 11.7%, from inside the long term 5.1% - 11.6% normal range to outside the range. On this measure, the US was last at Full Employment in September 2006. At that time, labor force participation was at 66.4% and the narrow unemployment measure at 4.1%. The Biden Administration sees the possibility of driving broad unemployment below the long term 8.4% average during 2022, and finishing the year at 7.2% unemployment (62.9% participation), the best achievement since August 2008. US mid-term elections campaigning will certainly focus on employment in the Democrat camp.
Real GDP Growth
In Q3 2021, US Real GDP was growing at a 4.9% year-over-year rate, just outside the long term 0.3% - 4.7% normal range of growth. Real growth for 2021 will likely come in at 4.5%, and for 2022 we expect to see a 4.1% rate. This growth is exceptional when you think about the GDP deflator running at a 5.2% rate for 2022.
The resulting positive output gap of 1.6% for 2022 drives prices and solicits a monetary policy response from the Fed. The Fed will likely see this output gap as a net positive that protects their employment mandate, and will likely assign a zero or slightly negative reaction coefficient to this in 2022 (-.092 in the Taylor First Difference formula). My interpretation results in an adaptive Taylor formula rates decision that looks at history and optimizes current parametric response according to where inflation and output gap stands at the moment. This leads us to suggest that the upcoming decisions are all about addressing inflation expectations.
Real Personal Consumption Expenditures
Achievement of unemployment targets and avoiding stagflation risks heavily depend on this strong real growth. Behind this blockbuster growth is the assumption of a spendthrift US consumer, participating in the labor force, employed, confident, on a tear to live it up. I have Real Personal Consumption Expenditures rising 5.8% in 2022, well outside the long term normal 0.4% - 5.1% range. People do not necessarily spend more per capita, but a lot more people get a paycheck and add to existing spending.
Net exports
The US trade deficit will continue to build during 2022, and this will be a drag on US Real GDP growth. Monetary tightening already under way is bidding up the dollar and so making US exports relatively uncompetitive, while making some foreign imports attractive compared to domestically produced goods and services. This dampener on growth nevertheless could offset inflationary pressures as cheaper foreign goods substitute more expensive domestic ones. US Real Imports are expected to grow by 9.3% in 2022, well outside the -4.7% - 6.2% long term normal range of growth on the high side.
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Real Corporate Profits
I have recently changed my outlook for Real Corporate Profits from flat to plus 14.5% for the year - well above the long term 4.0% average growth rate. The impact on the outlook for share prices is dramatic. The inherent risk factors in the market shift to valuations, but if profits expectations are adjusted up, the high multipliers of the market could be seen as a one to two year forward pricing of an excellent profits growth outlook.
Real Gross Domestic Private Investments are likely to grow well above average, in part driven by corporate profits, albeit remaining within the long term normal range. Real Government Consumption Expenditures and Gross Investment will likely underperform compared to market expectations, and also compared to long term average real growth rates.
Long Term Treasury Yields
As the Fed is the highest bidder in US Treasury auctions - at least for 5.7 trillion dollars worth of bonds - the US Treasury is paying less for debt than in the absence of the Fed as a superbuyer. There is an active yield suppression taking place lead by the Fed. US 10-year Treasury yields will be stable throughout 2022 and finish the year at 1.56%, just barely higher than the current 1.51% yield. Current yields are artificially low and one can argue that the Fed will be able to manipulate yields to fit is own agendas. This would mean ending the purchases (tapering completes this first quarter of 2022), and potentially also net sales to allow yields to come back into the long term 2.3% - 6.9% normal range. At 8% inflation, long term Treasury real yields in the US are deeply under water and one would argue that the Fed would have difficulty finding buyers until inflation is under control - a formidable Catch-22.
Neutral Policy Rate
At this time I estimate that we closed out 2021 at a Real Neutral rate of 0.7% and that this will be falling to 0.5% during 2022. If the Neutral rate is the monetary policy rate at the target inflation rate with the output gap closed, it results that we would be at a 0.7% + 2.2% = 2.9% rate today, if you allow me to suggest that the target rate is the long term average rate (2.2%) rather than the infamous "2%", notably debated and considered for change by many Fed commentators and economists since 2008. In order to get to equilibrium from here, the adapted Taylor First Difference rule recommends a 5.5% nominal policy rate at the end of 2021, rapidly rising to 6.25% in Q1 2022, given the very high inflation today and projections over the coming year. This rises to 7.25% at the end of 2022.
Fed Funds
The Fed risks creating financial instability by following formulae and not making situation specific analyses and decisions made on these. In my view, we are witnessing brinksmanship driven by the employment goal of the Fed, rapidly coming within reach and inconveniently disturbed by the onset of rapidly rising prices.
The Fed should hike by 1.25% at the earliest opportunity, indicating they are getting serious about inflation. I sincerely doubt that they will get further than a second hike in Q4 2022 to 1.50%. Any hikes beyond this will likely raise the possibility of recession coming around the 2024 time frame, whether brought about by the Fed raising rates or by inflation allowed to run for longer than consistent with the Fed remaining in control of its dual mandate. The Fed will be looking to create headroom for further hikes, as well as seeking alternative or complementary measures to raising the overnight Fed Funds rate.
Inflation at 5% plus levels were delivered by design and fully expected consequences of the COVID-19 response package pursued by the Fed in coordination with Treasury. What was unexpected to the Fed was that the inflation sources were not only of their own doing, but included global supply chain elements that confounded the timing issues. Their insistence on the transitory nature of inflation must be seen against this background - they made a mistake by overfocusing on their own inflation bomb and lost sight of the external global environment and its more lasting impact on prices.
The resulting problem is also a welcome one, in that the past 13 years or so of fighting deflation and trying to whip up inflation finally seems to have succeeded. The consequences for enterprises and their listed securities, investor holders of such paper and employees of same enterprises could be turning very negative if effectively financial conditions reflect the type of tightening the Fed would be expected to conduct under circumstances of 8% inflation.
Impact on capital markets
The discussion above suggests that we are facing a year with high economic growth, a very positive enterprise profits outlook, and this drives both employment and prices. I have documented that the Fed is constrained from raising rates and this creates a big gap between the rates required for fighting inflation, and the rates that can be seen as supporting economic growth without triggering recession. This gap grows from 5.5% at the end of 2021 to 5.75% at the end of 2022. The risk for capital markets is that the gap remains untenable and that the Fed will go all in against inflation, having found some partial headroom for raising rates beyond the 1.50% apparently at their disposal without causing harm.
I have no quantitative reason for predicting other rates than I have indicated above - a 1.50% Fed Funds rate at year-end 2022 and 10-year Treasury bonds at 1.56%. The implication of this on investor behavior depends largely on their perception of its sustainability in time as a Fed scheme with potential unsuccess in fighting inflation triggering rapid and substantial hikes. The base case implies yield curve flattening, and small consequences for enterprises and founders seeking capital until such time the yield curve flattening is translated into recession expectations, a negative output gap and residual inflation compared to Fed target to go with that. My stock market model turns all of this into solid gains also for 2022. The analyst in me sees an unsustainable set of circumstances where something will have to give. External shocks will have a larger potential impact as investors know valuations are stretched and depending on a dovish Fed. Inflation is rampant and could in itself trigger market selloffs if the Fed is perceived to be trapped or having made a policy mistake in deferring action.
We are back to the good old data dependency, watching every release for evidence related to a policy move by the Fed or potential investor portfolio realignment. I would near term then look at the Employment Situation Report coming out on Friday for first hints.
The market seems to underestimate the increase in hourly earnings at 4.1%, while I expect a 4.7% increase y-o-y. This will fuel suspicions the Fed will in fact be more ready to act with force in response to inflation.
The takeaways from the Employment Situation Report will likely be
- Accelerating payrolls growth at 4% y-o-y
- Accelerating inflation and wages jumping more in a move to catch up.
- Negative real earnings growth (-1.2%)
- Weekly payrolls growth at 2.2% y-o-y in real terms, inconsistent with Real GDP growth targets in excess of 5%
- Full-time Equivalents growing at 3.4% <4%, indicating December hiring reflected significant number of part time labor
Overall I expect a weak first quarter on the employment front, but this will all be more than corrected in the ensuing three quarters.
It is hard to recommend more than caution, while remaining invested in markets for 2022. Investors should seek to avoid companies likely to be hit more than other firms by rising prices and wages. Firms depending on exports (Koch Industries; International Paper) and so the value of the dollar will likely suffer, and those sensitive to foreign imports competition. Companies like Walmart, the largest US importer, will likely gain from a stronger dollar.
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