The outlook for 2021 focused on the impact of Covid-19 health outcomes on economic and financial conditions. Our view was that economic growth would prove unusually strong, with the prospect of an “inflation scare” as growth picked up. As we come to the end of 2021, parts of the economy and markets are out of balance. Labour demand exceeds supply, financial conditions are exceptionally strong even when compared to improved fundamentals and policy accommodation remains extraordinary.
Although health outcomes will remain important in 2022, the outlook for macroeconomic policy will be more crucial as support and stimulus packages enacted to combat the pandemic-driven downturn are gradually removed into 2022. The removal of policy support poses a new challenge for policymakers and a new risk to financial markets.
The global economic recovery is likely to continue in 2022, although we expect the low-hanging fruit of rebounding activity to give way to slower growth, whether supply-chain challenges ease or not. In both the United States and the euro area, we expect growth to normalise lower to 4%. In the UK, we expect growth of about 5.5% and in China we expect growth to fall to about 5% given the real estate slowdown.
More importantly, labour markets will continue to tighten in 2022 given robust labour demand, even as growth decelerates. We anticipate several major economies, led by the US, will quickly approach full employment even with a modest pick-up in labour force participation. Wage growth should remain robust and wage inflation is likely to become more influential than headline inflation for the direction of interest rates in 2022.
Inflation has continued to trend higher across most economies, driven by a combination of higher demand as pandemic restrictions were lifted and lower supply from global labour and input shortages. Although a return to 1970s-style inflation is not on the cards, we anticipate that supply/demand frictions will persist well into 2022 and keep inflation elevated across developed and emerging markets. That said, it is highly likely that inflation rates at the end of 2022 will be lower than at the beginning of the year given the unusual run-up in certain goods prices.
Although inflation should cool in 2022, its composition should be stickier. More persistent wage-based inflation should remain elevated, given our employment outlook, and will be the critical determinant in central banks’ adjustment of policy.
The global policy response to Covid-19 was impressive and effective. Moving into 2022, how will policymakers navigate an exit from exceptionally accommodative policy? The bounds of appropriate policy expanded during the pandemic, but it’s possible that not all these policies will be unwound as conditions normalise. On the fiscal side, government officials may need to trade off between higher spending—due to pandemic-driven policies—and more balanced budgets to ensure debt sustainability.
Central bankers will have to strike a delicate balance between keeping a lid on inflation expectations, given negative supply-side shocks, and supporting a return to pre-Covid employment levels. In the United States, that balance should involve the Federal Reserve (Fed) raising interest rates in 2022 to ensure that elevated wage inflation does not translate into more permanent core inflation. At present, we see the negative risks of too-easy policy accommodation outweighing the risks of raising short-term rates. Given conditions in the labour and financial markets, some are likely underestimating how high the Fed may ultimately need to raise rates this cycle.