Economic commentary: What does 2022 have in store?

What is the outlook for the global economy in 2022?

The emergence of the omicron variant clearly raises uncertainty and threatens to dent economic activity in the near-term. However, given the continued rollout of vaccination/booster programmes, along with the ability of consumers and businesses to adapt to covid restrictions, omicron is not expected to derail the global recovery. This said, even in the absence of omicron, growth in the world economy is likely to slow in 2022, as the easy ‘reopening’ gains of 2021 give way to more ‘normal’, trend rates of expansion.

The consumer should remain a key driver of growth in developed economies. Labour markets are strong and interest rates, while set to rise, are likely to remain at historically low levels. Following the sharp run-up in house prices and equity markets over the last year, household finances are generally in rude health. Against this backdrop, consumers should continue to run down the excess savings they accumulated during the pandemic. On one estimate, these excess savings amount to over 12% of household disposable income in the US and the UK1. These cash balances should provide a buffer against the recent squeeze on real income growth resulting from a pick-up in inflation and the withdrawal of emergency fiscal support measures.

In terms of spending patterns, 2021 saw a sharp rise in demand for manufactured goods (such as furniture, consumer electronics etc.), as people spent more time at home. Meanwhile, covid restrictions and fear of the virus curbed expenditure on travel, hospitality and leisure. In the near term, uncertainty regarding the omicron variant and renewed restrictions will work against a reversal of this trend. However, given tentative evidence that booster jabs and therapeutics are effective against the new variant2, there is potential for demand to shift from goods to services as the year progresses.

There are also good prospects for stronger business expenditure. Corporate profits have bounced back sharply in 2021 and capacity constraints, along with new ways of doing business (digital economy, automation, green transition etc.), are prompting businesses to step up investment. In addition, with stocks of goods in shops and warehouses running low due to ongoing supply chain issues, the rebuilding of inventories is also likely to make a significant contribution to global growth in 2022.

Precise numerical forecasts will almost certainly be wrong, but the Organisation for Economic Co-operation and Development (OECD) reckon that, following estimated growth of 5.6% in 2021, the global economy will expand 4.5% in 20223.

When will supply bottlenecks ease?

A series of factors including covid outbreaks, fires and extreme weather events have disrupted global supply chains over the last two years. This has constrained manufacturing output, lengthened delivery times and, given prevailing strong demand, put upward pressure on prices.

In recent weeks there have been some tentative evidence that supply chain issues are easing. After showing a near five-fold rise from pre-covid levels, shipping costs have started to fall back slightly4, and increased investment in shipping capacity bodes well for further improvement through next year. Furthermore, improved vaccination rates in Asia have lifted production5 and should reduce the chances of renewed factory closures (although the highly-transmissible omicron variant combined with China’s ‘zero-covid’ policy is clearly a risk on this front).

The shortage of computer chips has been a key factor behind disrupted supply chains, snarling up the production of manufactured goods ranging from household appliances to motor vehicles. Some industry experts suggest the chip shortage will not be resolved until 2023, but others such as those at JP Morgan see the situation improving during the second half of 20226. Much will depend on how the pandemic pans out, but if household spending does shift from goods to services, then softening demand could also help ease pressure on supply chains through the course of next year.

Will inflation fall back in 2022?

As economies reopened, global inflation picked up sharply through 2021 on the back of strong, stimulus-fueled demand, disrupted supply chains and rising energy prices. Some of the rapid price increases associated with reopening economies in 2021 (for example the jump in oil prices, and the spike in used car prices7 as chip shortages hit the production of new vehicles) are unlikely to be repeated next year. As a result, base effects in some price categories will serve to pull down annual inflation rates through the course of 2022. An easing of supply chain issues and a shift in consumer demand from goods to services should support a pull-back in inflation, and could even see prices for some items fall back in absolute terms.

Weighed against this effect is a broadening in price pressures resulting from rising wage costs in some countries, most notably the US and the UK. Labour supply has fallen due to a range of factors (e.g., fear of the virus, childcare issues, early retirement, reduced labour mobility), resulting in an increase in bargaining power for workers in certain industries.  However, an improvement in the covid situation, along with a depletion of excess savings among lower income groups, could result in more workers returning to the labour market in 2022. In combination with increased business investment (automation etc.), this could result in some moderation in wage cost pressures.

Omicron clearly has the capacity to boost inflation via the impact on supply chains, the composition of consumer demand and workers’ willingness to rejoin the labour market. However, the view here is that inflation in advanced economies will end 2022 below current rates, even though a continued overshoot of central banks’ 2% inflation targets in the US and UK seems likely.

What is the outlook for monetary policy?

A pick-up in inflation has already prompted many central banks in emerging market economies to raise interest rates during 20218, and several of their developed market counterparts are likely to follow suit in 2022 as emergency pandemic stimulus is withdrawn. The US Federal Reserve - the world’s most influential central bank - is on course to complete its Quantitative Easing (QE, or buying bonds) programme during the coming months, paving the way for interest rate hikes thereafter. Hawkish comments from Fed officials in recent weeks have prompted investors to bring forward expectations of monetary tightening9. Financial markets are currently pricing in three rate hikes for 2022, with the Fed Funds target rate seen ending the year around 0.75%10.

In the UK, markets currently expect the Bank of England to raise its policy interest rate to around 1% by the end of next year11. In the eurozone and Japan, where underlying inflation pressures are less pronounced, central banks appear unlikely to raise interest rates in 2022. Of course, the last twelve months have taught us that the outlook for interest rates can shift quickly. However, both market expectations and central bank guidance indicate that real (i.e., after inflation) policy rates are likely to remain negative in the major developed economies next year, suggesting that monetary policy, while becoming somewhat less expansionary, will remain broadly supportive.

What could go wrong in 2022?

An environment of moderating but still above-trend global growth combined with slowing but still above-target inflation as outlined above is a relatively benign one. However, there are clear downside risks to this ‘base case’ scenario. A coronavirus variant that evades vaccines and results in renewed restrictions is an obvious threat.

In light of regulatory tightening and ongoing woes in the property sector in China, a sharp slowdown in the world’s second largest economy would risk knock-on effects in emerging and developed markets alike. This said, a recent loosening in monetary policy from the People’s Bank of China suggests that Beijing is gradually moving to mitigate such risks12.

Geopolitical tensions (not least regarding Ukraine, Iran and US-China relations) also threaten to flare up in 2022. European gas prices have already risen sharply this year and a renewed spike in energy costs due to a deterioration in relations with Russia and/or unrest in the middle east could further drag on activity and fuel inflation13.

Indeed, persistent inflation that prompts more aggressive monetary tightening than markets currently anticipate is a key risk going forward. A sharp rise in interest rates could hit highly-valued asset markets and ultimately culminate in recession. The recent flattening of the yield curve (i.e., a reduction in the gap between the yields on long-term and short-term bonds) provides a warning on this front, as a fall in long-term yields below short-term levels (a so-called inversion of the yield curve) has often been a pre-cursor to recessions in the past14. This indicator is not flashing red yet – a model from the New York Fed based on the yield curve suggests the probability of a US recession by November 2022 is just 6.8%15 - but is one to watch.

14th December 2021