2022 should be the year in which the developed world learns to live with COVID-19. High levels of vaccinations have helped weaken the link between case rates and deaths in richer countries. Despite spreading at lightning speed and generating record case rates, the Omicron variant has been less damaging to health than previous waves.
The restrictions that came in the wake of Omicron dampened activity late last year, but better times are likely as this wave recedes. Equity investors are upbeat, with the US S&P index hitting an all-time high on 4 January, having risen by 9% in the final quarter of the year. In the UK our own survey shows that Chief Financial Officers (CFOs) of the countries’ largest businesses enter 2022 with a strong focus on expansion.
One reason for optimism is that the pandemic has inflicted less damage on the economy than feared. In my year-ahead piece this time last year I worried that “recoveries from deep recessions have often been retarded by economic scarring, and the dislocation and loss of skills, connections and capacity inflicted during the downturn….Unemployment [is]… almost certain to rise this year as the lagged effects of the recession weigh”. That prediction was wide of the mark. Muscular government intervention, in the form of debt-financed spending, cushioned the shock of the downturn in a way never seen in a post-war recession. Unemployment rates fell in most countries last year.
The dislocations caused by the pandemic have had remarkably little effect on growth, but a large effect on inflation. The on-off of production and consumption caused by the virus has created supply bottlenecks, backlogs of orders and queues at ports. The mismatch between supply and stimulus-fuelled demand has pushed inflation sharply higher.
From near-zero rates in late 2020 inflation in the OECD group of rich economies reached a 25-year high in November. US inflation hit 7.0% in December, a 40-year high. Inflation, rather than insufficient growth, is now the big worry for financial markets. If inflation stays high, the reasoning goes, central banks will be forced to raise interest rates aggressively. That could threaten the recovery and knock what, by historical standards, are expensive equity and bond markets.
In common with most economists, we don’t expect that to happen. Like the swings in activity seen in the pandemic, inflation should normalise with time and as disruptions ease.
To see why we need to look at the composition of inflation. In normal times goods inflation runs below services inflation reflecting the more capital-intensive nature of goods production that generates faster productivity growth (in essence goods production can more readily be automated than the output of services).
Yet in a reversal of the normal rules, goods inflation in the US, and much of Europe, is now running at roughly three times rates of services inflation. Pent-up consumer demand for goods has fed through to constrained supply, helped by online shopping. Demand for services has been more muted, partly because of COVID restrictions, and partly because consumers don’t ‘catch up’ on disrupted consumption of some services, such as haircuts or bus journeys.
The result has been shortages of goods and higher prices. Semiconductors, a ubiquitous component is manufactured and durable goods, have been in short supply, pushing up the price of many manufactured goods. Car production has suffered, and, with consumers switching to second-hand cars, prices here have soared. US second-hand car prices have risen 37% over the last year. Energy prices have also jumped from the pandemic lows, buoyed by colder weather, supply problems and low winds, which have reduced output from wind farms.
Some blockages in the system are starting to ease. The cost of shipping freight and bulk natural gas is down from last year’s peak. Delivery times in US manufacturing are no longer increasing. Pent-up demand will fall away this year. A few rough months are in prospect, but by summer inflation rates should be on a downward path.
That is unlikely to stop the US Federal Reserve and the Bank of England from raising interest rates. Financial markets see US short rates rising by around 100bps in the course of 2022, UK rates rising roughly 75bps and euro area rates staying broadly unchanged. That would leave US and UK rates at a still-low 1.0% by the end of the year with euro area rates still in negative territory.
Consumers are likely to keep spending this year, with the focus moving from goods to services. Inflation will hit spending power, but there are offsets. A tight labour market points to good growth in wages and employment. High levels of savings and buoyant housing and equity markets have boosted consumer wealth.
Growth in capital expenditure should outpace GDP growth this year as cash-rich corporates seek to expand capacity and capitalise on the recovery. UK CFOs are more bullish about investment now than at any time in the last 12 years.
Despite falling unemployment rates, too many people are on the sidelines of the workforce. More young people are prolonging education or taking time out; among those in work, rates of retirement and sick leave have risen. Pandemic-related disruptions have slowed the international movement of people and caused some foreign-born workers to return home, further squeezing the labour supply. In the US the rate at which employees voluntarily leave their jobs has risen to record levels, prompting talk of a “great resignation”. Unemployment is likely to fall further this year, tilting the balance of power in the labour market further in the direction of workers.
The International Monetary Fund forecasts that after last year’s strong bounce back, and global growth of 5.9%, the world economy will expand by a respectable 4.9% this year. On average independent forecasters expect the US, euro area and the UK to grow by about 4.0% this year.
There are significant risks to this view. COVID-19 is more widespread than ever, all but guaranteeing the emergence of new variants. It is impossible to rule out the arrival of a transmissible, vaccine-resistant virus. Countries with low levels of vaccinations, generally in emerging economies, remain vulnerable. The arrival of the highly transmissible Omicron variant in China could challenge its effective, but economically disruptive, zero-COVID policy.
Meanwhile, the threat to growth from inflation and labour shortages cannot be discounted. The accumulation of debt by governments, businesses and in emerging market economies during the pandemic has created new vulnerabilities. Stretched valuations for equities, especially among US tech stocks, are a further worry.
As for the most likely outcome, 2022 looks likely to be a year of good global growth and gradually falling inflation. We’ll be assessing how that prediction is playing out over the course of this year in future briefings.
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