May 6, 2022
In our view, it is increasingly clear that the 1.4% GDP decline in the first quarter was largely caused by supply line challenges rather than any significant drop in demand. Early in the second quarter the monthly purchasing managers indexes continue to register growth in orders, and firms’ ability to ramp up production is being constrained by supply chain problems. The employment reported confirmed that through April employment is expanding rapidly. As additional data become available it is increasingly evident that the first quarter GDP drop was seriously distorted. Meanwhile, the inflation outlook has not improved. The core CPI has risen 6.4% in the past year. But the overall index which includes food and energy prices has climbed 8.6%. Finally, last week the Fed did what it was expected to do with a 0.5% increase in the federal funds rate and suggested that it was on a path to the 2.5% mark by yearend. Unfortunately, that will leave real interest rates sharply negative. Thus, the debate continues. Will the Fed’s expected rate hikes be sufficient to slow the pace of economic activity? When will the inflation rate reach a peak and begin to subside? How high will the Fed need to raise rates to reduce inflation to the 2.0% mark? Can it pull off a soft landing, or will it go too far and push the economy over the edge into recession? No wonder the stock market is jittery! In the end, higher rates and supply interruptions will take a toll on growth in 2022. We now expect GDP growth for the year of 2.0%. But at some point these supply challenges will end. For this reason we expect 2023 GDP growth of 2.5% as the stimulus provided by improvements in the supply chain is partially countered by the impact of higher interest rates
Regarding the first quarter GDP decline, we know that firms were hiring workers. As a result, the aggregate hours index rose 4.7% in the first quarter. But yet GDP declined 1.4%. Why didn’t output rise as sharply as hours worked? Our guess is that firms’ inability to get critical materials combined with transportation delays in both receiving materials and shipping produced goods constrained economic activity. As a result, productivity growth plunged 7.5% in the first quarter. But productivity data are notoriously volatile. In the end we think that productivity will climb at its historical average rate of roughly 1.0% going forward. If so, we should not expect additional GDP surprises in the quarters ahead.
It is also worth noting that the second quarter is starting off on a strong note. Two pieces of information are worth noting. First, in April the purchasing managers indexes reported by the ISM cited comments made by nine survey respondents and all nine of them highlighted the fact that supply line challenges curtailed their ability to produce goods. Manufacturers are anxious to step on the gas not the brake. Second, 428 thousand jobs were created in April and employers continue to report a record number of job openings. Meanwhile, in early May layoffs and the number of people receiving unemployment benefits were at their lowest levels in 50 years. Interest rates have been steadily rising since the end of last year but businesses have seen little drop in demand and continue to hire as fast as they can.
On the inflation front the core CPI has risen 6.4% in the past year. Economists like to exclude the food and energy components because they tend to be volatile. While that generally makes sense, in this situation it is hard to see how either of these two categories can decline in the foreseeable future. Commodity prices for food surged in March because Ukraine is a major exporter of wheat and corn and those supplies have largely been eliminated. Energy prices got a significant boost once the war began as the supply of oil and gas will be reduced. Meanwhile, Biden and his administration are dong all that they can to hamper oil production in the U.S. Crude production at 11.9 million barrels per day remains far below the pre-recession level of 13.1 million bpd. It is hard to see how energy prices are going to decline any time soon. This means that economists should not dampen the inflation problem by excluding the food and energy components. The overall CPI index has risen 8.6% in the past year. The starting place for any future inflation drop is a lot farther from the Fed’s desired 2.0% pace than is generally believed.
As noted, food and energy prices seem unlikely to decline. But also, rents (one-third of the overall CPI) will not start to slow until such time as builders can crank up the pace of production. To make that happen they must hire more bodies and be able to get the requisite building materials. At the same time labor costs are on the rise. The best measure to watch is unit labor costs. Labor costs adjusted for the change in productivity have risen 7.2% in the past year. It is hard to see how extreme tightness in the labor market is going to change any time soon.
So where are we? The rate of growth in the economy may be faster than is generally expected at the moment. The inflation rate will probably be worse than expected. That means the Fed will have to raise rates a lot higher than the 2.5% it currently suggests for the end of this year, with further substantial increases in store in 2023. Our 3.5% projected funds rate at the end of that year is likely to be too low. GDP growth of 2.0% or more in the next two years is good for the stock market. Higher inflation will give firms some pricing power which is also good for the stock market. The fly in the ointment is higher rates. It is a tug of war and we understand the market’s concerns but our sense is that the current stock market pessimism is overdone and that stocks will rebound as the year progresses.