Direct federal government spending is likely to increase only slowly over the next two years. However, both state and local government spending could increase more rapidly due to strong revenue growth and the lagged effect of federal government stimulus. Finally, we expect trade to be a relatively neutral factor in driving growth as economic recovery in the U.S. and overseas results in parallel gains in exports and imports.

Supply: The Labor Constraint   
Adding up the pieces of demand suggests real GDP growth of close to 5.0% in the second half of 2021 and the first half or 2022 and then slowing to a roughly 2% to 2.5% pace thereafter. One important question is: what this will mean for the job market? 

While the August jobs report was a disappointment, showing the addition of just 235,000 non-farm payroll jobs, it is clear that this reflects a lack of labor supply more than a lack of labor demand. In particular, even this slower pace of job growth was sufficient to boost average hourly earnings for production workers by 0.5% or 4.8% year-over-year. This higher wage growth, combined with the expiration of enhanced unemployment benefits at the start of this month, should elicit some increase in labor supply. However, the labor shortage is likely to continue throughout the next few years as a combination of baby-boom retirements and limited immigration makes it difficult to find qualified workers. Overall, we expect employment to be up 3.4% year-over-year in the fourth quarter of this year but then rise by just 2.2% year-over-year by 4Q 2022 and 1.4% year-over-year in the following year, cutting the unemployment rate to 3.5% by the end of 2023. 

Strong productivity growth has been one of the hallmarks of the pandemic recession and recovery with output per worker rising at a 3.7% annualized pace in the 18 months ended in the second quarter of 2021. 

Businesses may well be able to bank most of these short-term gains. However, with the recovery slowing, it is unlikely that productivity will continue to surge. While investment spending should be strong, productivity gains from this source will take some time to materialize and we expect output per worker to rise by just 1.4% over the course of 2022 and 0.8% over the course of 2023. Combined with the growth in employment, this suggests real growth of 6.0% year-over-year by the fourth quarter of 2021, slipping to 3.3% over the following year and 2.2% in the fourth quarter of 2023.

Inflation: More Than Just Transitory  
If the economy does follow this path, then most, but not all, of the current inflation surge in the economy should abate. Even assuming moderate inflation of between 0.2% and 0.3% per month between now and December, the year-over-year inflation rate, as measured by the personal consumption deflator could average 4.6% in the fourth quarter. 

Inflation should moderate in 2022 as supply chain disruptions are ironed out and demand grows more slowly. However, a number of factors should conspire to keep inflation more elevated than at the end of the last expansion. These include strong wage growth, higher inflation expectations, a falling dollar and the lagged effect of higher home prices on rents. Consequently, we expect consumption deflator inflation to fall to 2.7% year-over-year by the fourth quarter of 2022 and 2.4% year-over-year by the fourth quarter of 2023—still well above the Federal Reserve’s long-term target of 2%. 

The Fed: Still On Track To Taper
At their meeting in June, the Federal Reserve projected that, by the fourth quarter of this year, real GDP growth would be 7.0% year-over-year, the unemployment rate would be 4.5% and consumption deflator inflation would be 3.4% year-over-year. When they meet later on this month, they will likely downgrade their growth forecast and project a somewhat higher unemployment rate. However, they will likely also have to increase their estimate of inflation. 

Given the recent deterioration in economic data and considerable uncertainty about fiscal matters, the Fed is unlikely to lay out a plan for tapering bond purchases at its September meeting. However, we expect that they will do so at their November meeting and will cut bond purchases to zero by July of next year. This should open the door for a 0.25% increase in the federal funds rate in December 2022, followed by four more over the course of 2023.

Profits: Slow Growth From A Very High Place    
All of this, of course, will have an impact on corporate profits. After a truly spectacular 2021, in which we now expect S&P500 operating earnings to rise to nearly $200 per share, more than 25% above their 2019 record, profit growth should slow dramatically to low single-digit gains in both 2022 and 2023. Indeed it is hard to forecast anything better, since companies will be facing accelerating wage costs, higher interest rates, slowing revenue growth and, we assume, an increase in the federal corporate income tax rate to 25% from its current 21%.