However, since consumer spending and private fixed investment spending account for roughly 86% of GDP combined, strength in these areas should dominate, resulting in real GDP growth of 3.5% in the year ended in the fourth quarter of 2022—well above the economy’s long-term growth potential of about 2% and the Fed’s projection of 2.8%.
Importantly, it is hard to see how even the seven interest rate hikes the Fed projects for 2022 will put a dent in this growth. The most interest sensitive sectors of the economy, homebuilding, capital spending and, to a lesser extent, auto sales, are all experiencing massive pent-up demand which is unlikely to be reduced significantly by modest increases in very low interest rates.
Similarly, the labor market is seeing dramatic excess demand with 5 million more job openings than unemployed workers. This, in combination with solid GDP growth, should lead to strong job gains in 2022 with the unemployment rate likely falling significantly from February’s 3.8% reading. Indeed, with much stronger wage gains and still limited labor supply due to demographic issues, the unemployment rate could easily fall a further 0.5% by the fourth quarter, putting it at its lowest level since 1953 and below the Fed’s current projections of 3.5%.
The core consumption deflator was up 5.2% year-over-year in January and, we estimate, may have been up 5.5% year-over-year in February. The Federal Reserve expects this to fall to 4.1% year-over-year by the fourth quarter and we estimate that it could fall a little further to roughly 3.8%. However, this would still leave it far above the Fed’s long-term 2% target by the end of 2022. Moreover, with still strong wage growth and higher inflation expectations, it seems quite possible that core inflation will still be above 2% by the end of 2023.
And this gets to the key question for investors. If the economy does not appear to be cooling down in the face of a now-projected seven rate hikes in 2022, will the Federal Reserve be more aggressive in raising rates in 2022 or exceed their now projected four rate hikes for 2023? Will they reduce their balance sheet more aggressively to try to raise long-term interest rates and elicit a greater response from the more interest sensitive sectors of the economy?
The Fed’s communications last Wednesday, both in their forecasts and in Chairman Powell’s comments after the meeting, suggested that they are now willing to take this more aggressive stance. If they maintain this attitude and become frustrated by their lack of progress in dampening inflation, we could be in for a period of significantly higher real interest rates. This would tend to be negative for fixed income markets, of course, but also for stocks trading at high multiples and more speculative areas of the market. It could be positive for value stocks and international stocks, which trade at lower multiples and also could favor short-duration fixed income.
Eventually, fiscal drag from Washington, private sector efforts to attack supply-chain issues and the long-term forces that led to declining inflation in the four decades before the pandemic recession should erode inflation. However, if the Fed is sufficiently determined to battle inflation in the short run and frustrated in its lack of short-term success, America may have reverted to an era of higher and more normal interest rates by the time the inflation tide finally begins to ebb.
David Kelly is chief global strategist at JPMorgan Asset Management.