Falling GDP and inflation add to uncertainty in the US economic outlook.

US and global economic and financial conditions have weakened over the past three months. This weakness reflects many factors, including the Russia-Ukraine war and a rise in US inflation that has triggered expectations of more aggressive action by the Federal Open Market Committee (FOMC) to increase its target range for the federal funds rate and reduce the size of your balance sheet. Still, demand for labor and for goods and services in the US remained strong through the first four months of 2022, despite reductions in real household purchasing power due to unexpectedly high inflation. . The highly uncertain nature of the economic outlook has led many forecasters to lower their projections for US real gross domestic product (GDP) growth in 2022 and 2023 to a rate closer to trend growth (approximately 2%). Forecasts at the beginning of the year had indicated that real GDP would grow at a rate well above this rate.

An unexpected drop in GDP

Real GDP declined in the first quarter of 2022 at an annual rate of 1.4%, after a gain of almost 7% in the previous quarter. A decline in real GDP is generally seen as a bad omen, as it can indicate weakness that often occurs before a recession. However, declines in real GDP during trade expansions have happened before, and often due to one-time events, such as severe weather. The decline in the first quarter was largely due to sizeable declines in real net exports and the rate of real investment in nonfarm inventories, which together subtracted 4 percentage points from real GDP growth. On a brighter note, personal consumption spending and nonresidential (business) and residential fixed investment combined to account for just over 3 percentage points of real growth. Thus, the demand for real goods and services remained healthy, since final sales to private domestic buyers increased 2.6% in the first quarter, almost 1 percentage point more than the increase in the previous quarter.

Headwinds, tailwinds and eddies

The strengthening in demand for goods and services was impressive as several headwinds hit the US economy in the first quarter of 2022. These included:

• Russia’s invasion of Ukraine and the subsequent imposition of widespread sanctions against Russia by Western countries that led to sharp increases in the prices of energy and non-energy raw materials.
• A resurgence of COVID-19 cases in China that led to severe lockdowns in several major cities and the closure of many manufacturing facilities and ports.
• A surge of the omicron variant in the US that pushed daily COVID-19 case rates (per million) to a record high in January, prompting some consumers to postpone travel and other leisure activities and entertainment.
• Policymakers raised the policy interest rate and announced several additional rate hikes in 2022. These actions led to sharp increases in long-term interest rates (including mortgage rates), strengthened the dollar, and lowered prices of actions.

In addition, businesses and consumers continued to grapple with shortages of key manufacturing inputs (such as semiconductors), continuing bottlenecks in the production and distribution of goods, mounting cost pressures, and the inability to fill many vacancies, in particularly those of leisure and hospitality. industries

prices under pressure

Perhaps the biggest hurdle facing the US economy over the past year has been the exceptionally high rate of consumer price inflation, which hit a 40-year high in March 2022. Inflation is a tax on cash balances of the homes. Furthermore, if nominal household income does not increase as fast as inflation, the real standard of living for households falls. This is called a loss of purchasing power. In the first quarter of 2022, the labor cost index for private workers, the most comprehensive measure of workers’ compensation (wages, salaries and benefits), increased 4.75% over the previous four quarters; this was the largest increase in more than 31 years. However, the personal consumption expenditures price index, the Fed’s preferred measure of inflation, rose further in the first quarter, to 6.3%, from a year earlier. Thus, in real terms, worker’s compensation fell around 1.5 percentage points in the first quarter compared to the previous year. In fact, real labor compensation has declined for four consecutive quarters. Unless reversed, declines in real compensation pose a threat to consumer spending, the largest component of real GDP. Encouragingly though, real retail sales and industrial production rose more than expected in April.

The economy has continued to benefit from several tailwinds, including strong demand for labor that pushed the unemployment rate back down to 3.6% in April 2022, near the 50-year low of 3.5% that posted in January and February 2020. Business capital spending remained strong, helped by strong profit margins. In fact, some companies have increased their spending on labor-saving capital goods in response to rising labor costs and the inability to fill vacant positions. Housing also continued to be a source of strength for the economy, benefiting home sellers, lenders and builders and spurring double-digit percentage gains in home prices. In fact, rising house prices have helped offset some of the wealth loss from this year’s sharp decline in stock prices. However, history suggests that rising mortgage rates will eventually cool the real estate and mortgage markets.

see through the glass darkly

The outlook for the economy in 2022 and 2023 has dimmed considerably in the past six months. Although some economic analysts are predicting a recession sometime in the next 12 to 18 months, the Philadelphia Fed’s May survey of professional forecasters forecasts real GDP to rise 2.5% in 2022 and 2.3% in 2023. The unemployment rate is forecast to average 3.6% in each year. In short, it’s hard to have a recession with strong labor demand. That said, high levels of uncertainty often lead households and businesses to delay or cancel spending, which can result in lower growth. Therefore, risks to GDP growth are now tilted to the downside. From an inflation standpoint, cost pressures (labor and non-labor costs) remain intense for most businesses, and many have had little difficulty passing these higher costs on to consumers. Consequently, the longer inflation stays well above the Fed’s 2% target, the more likely it is that the FOMC will need to raise its benchmark rate more than markets expect.

Devin Werner, a senior research associate at the Bank, provided research assistance.

final notes

1. Trend real GDP growth is a long-term concept. At a high level, it is the sum of the growth rate of the economy’s labor productivity (output per hour) and the growth rate of the labor force that would be expected to prevail when the economy’s resources are operating at their normal capacity. .
2. Final sales to private household buyers are the sum of personal consumption expenditures and gross private fixed investment. Look at this Bureau of Economic Analysis Glossary.