Now What?

By Jeanette Garretty, Chief Economist

April 29, 2022 – First Quarter US GDP growth has landed with a resounding thud. Yes, consumer spending and business investment grew strongly, preventing the GDP growth number from being far worse than -1.4%. The preference, therefore, would be to look past the “special factors” with a negative growth impact: 1) the inventory building which contributed to measured economic growth in the fourth quarter of 2021 reversed itself in the first quarter of 2022, drawing down GDP growth as product shipments sped up and deferred consumer and business demand for various products was fulfilled and 2) the widening trade deficit showed robust consumer spending directed abroad (imports) sharply outpacing US exports. However, this viewpoint carries a whiff of defensiveness by analysts who consistently overestimated economic growth across the quarter, with virtually no one anticipating a negative growth number (the notable outlier is the Atlanta Fed GDPNow real-time estimate of economic growth, the last estimate for the quarter being 0.4%; the difference between 0.4% and a negative number is academic.)

It is appropriately reassuring that the negative economic growth of the first quarter was not accompanied by damage to the labor force and to household and business balance sheets; that is not always the case. Yet, there is so much that has happened in the first quarter that it seems naïve to waive off the implications of a disappointing GDP growth figure so easily. It is almost physically difficult to remember that in January, a rise in Omicron cases had curtailed economic activity (in ways we cannot imagine happening now), in early February, the Fed was still cautiously approaching the issue of higher inflation and deferring quantitative tightening, the actual reduction in the Fed balance sheet, until the Fall of 2022 (it’s now moved into the Spring, even though there remains great uncertainty as to its impact on the economy), and as late as the third week of February an actual Russian invasion of Ukraine was thought unlikely. At the beginning of the year, headlines about the unionization of “new economy” labor forces were an oddity, not a dominant feature of the business pages. On February 1, the 30-year fixed mortgage for a new home purchase was 3.82% (it’s now above 5%). The average price of oil in the first quarter was 23% higher than in the fourth quarter of 2021, with the price of West Texas Intermediate crude topping $90 on February 3, for the first time since 2014.

Remembering what has transpired since the start of the Ukrainian war in late February is somewhat easier. Specifically, global financial and product sanctions that have never been witnessed before and certainly were not contemplated in terms of their breadth and effectiveness. Upward pressure on commodity prices has been an early, visible result of these sanctions.  A more subtle effect has been in contributing to a worldwide re-think of globalization and its associated logistical costs that were already a dominant item in corporate boardrooms and small business order books as a result of the pandemic. Equity markets have become firmly entrenched in correction mode, while the Fed turned unequivocally to hiking interest rates sooner and faster than once thought remotely possible.   Additionally, though admittedly based on circumstantial evidence, it seems as though March was when the full force of rising prices caught consumers’ attention, perhaps because of the headlines about rising commodity prices or possibly because of a reduced concern about COVID. There is, after all, only so much the human brain can absorb and focus attention upon at any one time.

In no way, shape, or form can one assume that what happened in the first quarter of 2022 stays in the first quarter. Despite Las Vegas’ famous mantra, there are always follow-on consequences. Consumers possibly will adjust faster to changing economic conditions than businesses, which tend to settle on business plans at the end of the previous year and do not deviate from them casually or in a mere three months. Across the board, however, it is most likely that the economic responses to all that has transpired in the first quarter are yet to come. High employment and rising wages should provide an important cushion against declining growth, allowing consumer spending to continue to do what it does best: pull the US economy forward like an indefatigable freight engine. Thus, the biggest question centers on the business response and the impact on both business spending and business hiring. As the ability of businesses to pass on cost increases meets end-market resistance, will smaller margins be accepted or will costs, including labor costs, be trimmed in the hope of maintaining profitability? And where will that then take us?

At present, “hope” is as good as anything else and perhaps the best that we have after these tumultuous years. Hope for a soft-landing by the Fed. Hope for a medical victory over the terrors of current and future pandemics. Hope in resilient, dynamic economies with an often under-appreciated ability to respond, over time, to the greatest challenges. But “hope” only provides the most amorphous strategy, and no tactical guidance whatsoever. As is often the case, the risks are seemingly far more concrete, even though they are just that, risks. Perhaps a different approach is a broader understanding, a context for the changes, hopes and risks of this challenging year.

The Great Recalibration

Since modern time immemorial, parents have imposed “time-outs” on troublesome children. The visual image of a child seated in a corner facing a wall symbolizes not just punishment but a time to think over one’s behavior and form a resolve to follow a better way. There has been much written during 2020 and 2021 about how economic lockdowns, medical fears, and social conflict have caused people to think deeply about their relationship with their family, community, employer, future, technology, work etc. – an economic “time-out”, sometimes literally. And then, as the world emerged from the imposed isolation, it is as if it discovered that the long economic expansion which began in 2009 deposited everyone on a foreign shore, requiring old skills, new skills, re-invented skills. This adjustment is going to take prolonged effort and time, and it can be expected to happen unevenly.

 As a result of slow population growth, labor power is likely to be stronger than it was in the first two decades of this century, a period of time that may be more of an aberration than commonly realized.  Inflation, which has hovered well below 2% for a number of years, may return to something closer to the constructive financial planning number of 3% used in the late 1990s. Borders, long ignored by globalization, may re-emerge as demanding the respect they have usually had, and causing the problems they have always caused in the longer view of history. Money perhaps will finally have a price above 0%, which is far more typical—and economically sensible — than recent circumstances.  Finally, the twenty-plus year view that economic interests will unfailingly mitigate social or political conflict may need to incorporate a more realistic view of how the world works and a deeper understanding of national economic security (three words that should always be recognized for their cohesion, national security being dependent upon economic security and vice-versa.) These developments do not represent catastrophe, but they do pose challenges; they do not mark the future as “worse”, just different.  And it is in that difference that growth happens.

Near-term developments are potholes in this road, but without a long view, they can appear to be craters. Chief among these is, without a doubt, the tightening of monetary policy by the US Federal Reserve and the impact on consumer, real estate and business finances. The unknown territory of undertaking quantitative tightening while simultaneously raising interest rates, accompanied by a weakening Japanese yen that potentially reduces the demand for US Treasuries by the largest foreign holder of US government securities (Japan), makes interest rate forecasting especially problematic at the moment. It seems reasonable to assume that mistakes will be made, both by the Fed and by borrowers and investors. Volatility has an economic cost, at minimum tending to constrain business investment and planning, where certainty is much preferred to uncertainty. It is wise, in this environment, to form modest expectations for US and world economic growth and look for the greater stability that may come in 2023.