2022 will be a year of transition for the national economy

Editor's note: This is an excerpt from the recently released 2022 Greater Oklahoma City Economic Outlook. 

Read the full 2022 greater oklahoma city outlook. 

Read the 2022 Oklahoma Outlook.

Read the 2022 Oklahoma City Outlook.

The story of 2021 is one regarding the false sense of economic strength created by an unprecedented economic policy response to 2020’s COVID-19 pandemic. Fiscal policy has allocated or set aside more than $4.5 trillion in relief spending, while monetary policy has been supported by a nearly $5 trillion increase in the Federal Reserve’s balance sheet. U.S. gross domestic product recovered to prepandemic levels while the national unemployment rate fell to 4.2%. Holiday retail sales were strong and local governments reported record tax collections. On the surface, the economic engines of the nation are roaring. But a closer inspection reveals subtle cracks in the façade of strength.

In the second quarter of 2020 much of the nation retreated to a safer-at-home response to the initial spread of the coronavirus. As restaurants, factories, offices, and retail storefronts closed or severely restricted operations, U.S. 2022 ECONOMIC FORECAST 11 gross domestic product collapsed at a -32.4% annual rate. Traditional payments to workers via wages and salaries collapsed in parallel with halting economic activity, yet personal income jumped in the second quarter at a 36% annualized rate. Another 56.8% jump was posted in the first quarter of 2021. The incredible gains in personal income reflect government transfers that far exceeded losses in wages and salaries.

The main categories of government social benefits to persons (or personal transfer receipts) are Social Security, Medicare, Medicaid, federal unemployment insurance, veterans’ benefits, and “other”. The “other” category captures much of the pandemic relief spending such as direct impact payments and, more recently, expanded child tax credit payments. In the second quarter of 2020, a combination of direct economic impact payments and federal supplements to unemployment insurance drove personal income higher. The second round of direct payments followed by an expansion of the child tax credit provided additional support to other transfer receipts throughout much of 2021. It is precisely these dramatic policy responses that propelled measured household income higher amid an economic shutdown.

The indirect impact of the policy was almost as significant. Monetary policy that drove short-term interest rates (i.e., the federal funds rate) back to zero were matched by successive rounds of quantitative easing to keep long-term rates low. The effect was to make riskier assets across all asset classes more attractive. The result has been record-high stock prices with the S&P leading the way in 2021 with a 26.9% return, followed by 21.4% gains in the Nasdaq Composite and 18.9% in the Dow Jones Industrial Average. Home price appreciation soared similarly. As liquidity surged in search of riskier assets and their corresponding returns, cryptocurrencies thrived, and non-fungible tokens entered our financial lexicon.

The strength of household balance sheets is seen in a surging and sustained appetite for spending. After contracting briefly in the second quarter of the 2020 shutdown, retail and foodservice sales exploded with the reopening of the economy. Adjusted for inflation, real retail and foodservice sales not only recovered to pre-pandemic levels but broke the decade-long trend as sales jumped higher.

At the root of the 2022 outlook lies this truth – that household balance sheets are artificially strong. This artificial strength leads to a demand for consumption that may be unachievable but, when combined with supply chain disruptions, can only be inflationary. This artificial strength supports a great resignation, early retirements, and a labor force that is rethinking traditional engagement in the labor market. This artificial strength demands a return that risks creating asset bubbles across a range of asset classes. The year ahead will be a transition from a period of unprecedented income support to a one of normalizing policy. The challenge for policymakers will be to define “normal policy” and then implement it without disrupting what is, in reality, a fragile economic recovery.

By definition, of course, a policy change will disrupt the economic status quo. In this case, the economic status quo is a false sense of The indirect impact of the policy was almost as significant. Monetary policy that drove short-term interest rates (i.e., the federal funds rate) back to zero were matched by successive rounds of quantitative easing to keep long-term rates low. The effect was to make riskier assets across all asset classes more attractive. The result has been record-high stock prices with the S&P leading the way in 2021 with a 26.9% return, followed by 21.4% gains in the Nasdaq Composite and 18.9% in the Dow Jones Industrial Average. Home price appreciation soared similarly. As liquidity surged in search of riskier assets and their corresponding returns, cryptocurrencies thrived, and non-fungible tokens entered our financial lexicon. The strength of household balance sheets is seen in a surging and sustained appetite for spending. After contracting briefly in the second quarter of the 2020 shutdown, retail and foodservice sales exploded with the reopening of the economy. Adjusted for inflation, real retail and foodservice sales not only recovered to pre-pandemic levels but broke the decade-long trend as sales jumped higher. A best-case scenario is a policy change that disrupts economic activity just enough to cool inflationary pressures without significant disruptions to asset prices and the labor market recovery. This scenario is often referred to as a soft landing. A worst-case scenario is a policy change either that disrupts economic activity, either in magnitude or abruptness, so significantly that asset markets experience a major price correction, and the labor market gives back some recovered gains. This worst-case scenario is known as a recession. The truth is almost always somewhere in the middle: a soft landing is rarely achieved, yet a recession does not follow inevitably from a change in policy approach. The outlook for 2022 should be viewed as constantly evolving with every new release of data, as every new transition of policy provides some indication of moving closer to either the best- or worst-case scenario.

To the extent that history can be a useful guide in unprecedented times, the baseline expectation is that 2022 will be a year of transition with the real excitement deferred to 2023. The baseline outlook presented in the graphics below is consistent with this expectation. There is sufficient residual strength in household balance sheets and fiscal policy support not yet in the system that even if monetary policy begins to change course in 2022, economic recovery should press forward. Growth will slow, labor markets will continue to inch towards pre-pandemic levels, inflation will persist above its 2% target, and interest rates will generally move higher with adjustments to monetary policy.

Having recovered to pre-pandemic levels, growth in U.S. Real GDP is expected to slow in 2022. Barring an abrupt and unforeseen shock, the slowdown is more likely to be gradual rather than sudden. Baseline expectations have placed 2022 Q4 real GDP up 3.6% from a year ago but up only 2.6% from 2022 Q3 on an annualized basis (see graph below). The risk to this baseline forecast is strongly asymmetric to the downside. Much would need to proceed correctly with policy adjustments and residual strength would need to carry seamlessly throughout the year for 2022 to experience such a gradual move towards economic normalcy. It is also worth noting that economic activity is already moderating ahead of changes to the policy environment. Near the end of 2021, real disposable income fell modestly while real personal spending was unchanged in November from October. In other words, the hope for strength in 2022 lies not in policy flows supporting personal income, but in the residual strength of household balance sheets. The rate at which the year’s economic strength fades will likely be tied to the rate at which policy adjustments erode the strength of household balance sheets.

In contrast to measures of total economic activity (real GDP), labor market metrics have yet to return to pre-pandemic levels. A survey of employers indicates nonfarm payrolls are still down 3.9 million jobs from the February 2020 prepandemic baseline. The U.S. economy would need to add approximately 350,000 jobs per month for the next 12 months to return to the February benchmark. It is unclear if the economy can maintain this level of job creation through 2022. Regardless, it will be late 2022 at the earliest, and more likely well into 2023, before nonfarm payrolls return to pre-pandemic measures. A survey of households suggests that both labor market participation and level of persons identified as employed are struggling to return to the February 2020 benchmark. The hesitance to return to formal labor market engagement does not reflect a lack of opportunity. Instead, workers are rethinking how (and if) they want to engage in labor decisions. Households and workers are exploring and transitioning to a new set of economic behaviors and the strength of household balance sheets gives them some latitude to do so. A return to pre-pandemic behavior will not happen quickly and may not happen at all. A movement in the direction of pre-pandemic labor market participation behaviors is most likely to happen only as household balance sheet strength erodes.

For much of 2021, an argument persisted that it was because household labor participation was well below prepandemic levels that there existed a latent labor supply sidelined by the pandemic. Under this argument, falling unemployment rates did not necessarily imply a tight labor market as the unemployment rate lacked recognition of the latent labor pool. But the strength of the household balance sheet allows for these seemingly contradictory facts to both be true: household labor participation is below pre-pandemic levels, and the labor market is tight. A return to prepandemic labor market behavior will require a shift away from the new behaviors adopted during the pandemic. In some cases, households will find the new behaviors preferable and will be reluctant to return to old patterns of work. Only time and the erosion of household financial strength will change this behavior.

The pace of job creation will slow as policy-fueled recovery moderates into 2022. Unemployment rates will move to and hover around 4% to finish the year. Job creation in 2022 is expected to start the year averaging 431,000 new jobs per month in the first quarter and end the year creating 249,000 new jobs per month in the final quarter of 2022. As with real GDP, the risk strongly points to the downside. Evidence of a slowdown in the pace of jobs recovery is already evident with payroll gains in November of 249,000 jobs and gains of 199,000 jobs in December well below levels needed to reclaim 2020 pre-pandemic measures in the year ahead.

Monetary policy is traditionally crafted towards two targets: price stability and full employment. Price stability ostensibly means low and predictable inflation. Markets previously interpreted low and predictable inflation to mean near, but less than, the Federal Reserve’s 2% target. More recently, policymakers have worked to adjust that interpretation to view variations from the 2% target (slightly above or below) symmetrically. Even more recently, policymakers have worked to further adjust the interpretation by setting the 2% target as an inflation average over the business cycle. At the same time, policymakers have communicated full employment to mean more than a low unemployment rate, instead referring to a full and inclusive employment recovery. In practice, these changes have made it more difficult to assess when a policy has achieved its targets.

However low and predictable inflation is to be interpreted, inflation is well above the 2% target. Core personal consumption expenditure prices (excluding food and energy) have moved higher from the combined influence of policy fueled demand for consumption and supply chain disruptions in production. Which influence is believed to be stronger informs the extent to which inflation can be interpreted as temporary and transitory. The expectation for 2022 is that inflation remains consistently above the 2% target as both policy-fueled demand and supply chain disruptions linger well into the new year.

It is also clear that policymakers are signaling markets of an intention to shift policy in 2022. The chart below shows policymakers’ expectations of the appropriate year-end midpoint of the federal funds target range. For example, all eighteen members report an expectation that 0.125% is the appropriate 2021 year-end midpoint of a policy target range of 0% to 0.25%. Twelve of the eighteen members of the Federal Open Market Committee expect an appropriate policy move in 2022 to include at least three quarter-point increases in the target range. Eight members expect an appropriate policy target to be in the range of 1.75% to 2.25% by the end of 2023. While short-term interest rates are expected to move higher, policymakers have also announced an expedited tapering of bond purchases and a plan to manage the size of the bank’s balance sheet.

The outlook for the federal funds rate from the panel of NABE forecasters is well below the path indicated by policymakers themselves. This may imply that forecasters doubt whether policy appetite truly exists to change policy paths.

Flows of income support from expanded child tax credits or direct impact payments will subside in 2022 while monetary policy reduces its implicit subsidy to riskier asset classes. The more abrupt the policy change, the more abrupt the disruption to stock markets, real estate, cryptocurrencies, and other asset classes will be. The challenge for policy is always to support economic activity, when necessary, without creating harmful asset price bubbles and then withdrawing policy support without the risk of popping them. Unless and until inflationary pressures subside, policymakers will find the tradeoff of imposing price stability while also maintaining and supporting full employment to be increasingly challenging.

Finally, returning to the introductory discussion, it is worth noting that the U.S. outlook described above is most consistent with a soft-landing scenario. It is far more likely that residual strength carries the start of 2022 with the asymmetric downside risks manifesting more clearly as the year proceeds.