The US economy continues to recover from the widespread disruptions to labor and product markets caused by the pandemic. But the strong rebound in real gross domestic product (GDP) growth in 2021 was accompanied by high inflation, catching most forecasters and Federal Open Market Committee (FOMC) participants by surprise. With inflation on track to be the highest in more than 30 years, the FOMC, the Fed’s main monetary policymaking body, signaled at its December 14-15 meeting that it has accelerated the reversal of its inflation program. asset purchases (“phasing down”) that were announced at the start of the pandemic in March 2020. A new variant of COVID-19 (omicron) poses a downside risk to the US and global economic outlook in 2022. Another threat to the US economy is the possibility that inflation will remain high and more persistent than currently expected.
Consumer price inflation has surprised to the upside in 2021. For example, in February 2021, the Professional Forecasters Survey It projected the headline and core personal consumption expenditures price indices (PCEPI), which are the Fed’s preferred price measure, to rise 2% and 1.8%, respectively, in 2021 (Q4/Q4). By mid-November, these inflation forecasts had been raised to 4.9% and 4.1%, respectively. When all the data is available, the PCEPI headline and core inflation rate for 2021 is likely to have been the highest in 30 years or more.
Higher inflation also helped push inflation expectations, by some measures, to levels not seen in many years. Rising inflation expectations are concerning because they could indicate that households, businesses, and financial market participants expect high levels of inflation to persist longer than Fed policymakers expect; this would be an unwanted development.
Throughout the year, it became evident that a change in the dynamics of wages and prices in the economy was causing excessive increases in inflation. Many companies across multiple industries reported that labor shortages and supply disruptions were hampering their ability to produce and sell the volume of goods and services demanded by consumers. To fill vacancies and compete with other companies for scarce labor, many companies were forced to raise wages. When combined with material shortages that pushed up input costs, labor and non-labor unit costs began to accelerate. But businesses also reported strong demand for goods and services, allowing many to pass on their higher costs to customers. So when the FOMC called its final meeting of the year on December 15, 2021, it continued to face a development not seen in decades: companies willing and able to raise prices at staggering rates.
This was evident in the November Consumer Price Index (CPI) report, as the headline CPI rose nearly 7% in November from a year earlier, the biggest increase in more than 39 years. With an inflation rate showing little sign of returning quickly to the FOMC’s 2% inflation target, the FOMC announced at its December meeting that it plans to finalize its asset purchases by mid-March 2022. In addition, the 18 participants expect raise federal funds. target rate at least once in 2022. By contrast, at their March 2021 meeting, only four of 18 participants believed that an increase in the federal funds target rate in 2022 was an appropriate policy.
Most FOMC participants continue to project that 2021 will be the highest point for inflation in the future. (See figure below.) Additional improvements in supply chains that allow for a greater supply of durable goods, such as new vehicles; vaccines and other therapies that encourage more workers to rejoin the workforce; and the waning effects of large fiscal and monetary economic policies implemented in 2020-21, which could slow demand for goods and services, are some of the key factors forecasters point to in helping to reduce inflation over the medium term.
SOURCES: Summary of Economic Projections.
NOTES: Projections are the median projections of the Federal Open Market Committee (FOMC) participants. Projections for real gross domestic product (GDP) growth and inflation are the percentage change from the fourth quarter of the year prior to the fourth quarter of the indicated year. Inflation is measured by the chain price index of personal consumption expenditures. The projection of the unemployment rate is the average of the fourth quarter of the indicated year. The fed funds rate is projected path appropriate.
Near-term prospects for the economy and labor markets are good
The pace of economic activity slowed sharply in the third quarter after increasing at an exceptionally fast pace during the first half of 2021. However, improved economic and labor market conditions in October and November suggest that growth in the Real GDP in the fourth quarter could be the strongest. for the year, with growth for all of 2021 expected to be the strongest since 1983. Supported by the expectation of continued healthy financial market conditions, increased production to replenish tight inventories, higher gains in consumption of services such as food selections, consumer and business travel and a resilient real estate market, above-trend growth is likely to continue into 2022. At this point, real GDP growth of 3% to 4% is the most likely outcome.
Strong GDP growth will continue to be a boon for labor markets. The number of unemployed people actively seeking employment is at a record low relative to the number of job offers. Additionally, the number of people who quit their jobs as part of employment, often to look for higher-paying jobs, remains near a record high. Strong demand for labor is likely to drive the unemployment rate down to around 3-3.5% by the end of 2022 and drive continued strong growth in employee compensation. The latter will help mitigate the reduction in purchasing power of higher prices for goods and services. But if the reduction in household purchasing power due to rising inflation persists, consumers will have to cut real spending or withdraw their savings. Any of these developments could pose a threat to consumer spending and therefore real GDP growth.
Devin Werner, a Bank Research Associate, provided research assistance.
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