The U.S. economy picked up in the fourth quarter as COVID-19 infection rates subsided and vaccination rollouts progressed, allowing more people to get outside and spend. People have shown a willingness to forgive retailers for the higher prices as they prepare for long overdue visits with family this holiday season.

But finding these presents on the shelves has been tough, with supply constraints the main factor slowing the world's biggest economy. Supply disruptions have left businesses unable to meet surging demand, which we believe meant an over 1.2 percentage point haircut to 2021 growth this year from what we had expected in June. Fortunately, even with that haircut, 2021 growth is expected to reach a 37-year high. In this light, we revised down our forecast of real GDP growth for 2021 by 20 basis points, to 5.5%, after a 1.0 percentage point drop to 5.7% in September. Growth in 2022 will also slip, to 3.9% (was 4.1% in September). While disruptions across the supply chain of goods and services are expected to weigh on growth well into next year, there are signs that some pressures have abated.

Chart 1

Although the delta variant has ebbed, the pickup in COVID-19 infection rates abroad increases worries that the U.S. may be heading into another wave in the winter indoor season. Fortunately, disease experts believe that an outbreak today may not cause a severe health crisis, like last year, as close to 58% of the population is fully vaccinated. Moreover, the U.S. economy has adapted from past outbreaks, and to quote Federal Reserve Chairman Jerome Powell, "We've kind of learned to live with it." He noted in June that the impact to U.S. growth has been less severe with each wave, and it seems reasonable to assume this time will be no different.

S&P Global Ratings believes the new omicron variant is a stark reminder that the COVID-19 pandemic is far from over. Although already declared a variant of concern by the World Health Organization, uncertainty still surrounds its transmissibility, severity, and the effectiveness of existing vaccines against it. Early evidence points toward faster transmissibility, which has led many countries to close their borders with Southern Africa or reimpose international travel restrictions. Over coming weeks, we expect additional evidence and testing will show the extent of the danger it poses to enable us to make a more informed assessment of the risks to credit. Meanwhile, we can expect a precautionary stance in markets, as well as governments to put into place short-term containment measures. Nevertheless, we believe this shows that, once again, more coordinated, and decisive efforts are needed to vaccinate the world's population to prevent the emergence of new, more dangerous variants.

Inflation picked up dramatically in the U.S. in fourth-quarter 2021, with various price indicators reaching multidecade highs. The Consumer Price Index (CPI) is likely to reach 5.9%, moderating from its 30-year high of 7.9% in the second quarter. Core inflation is expected reach 4.9% in first-quarter 2022, though down from its 40-year high of 7.9% in second-quarter 2021. The Fed's preferred inflation indicator, the core Personal Consumption Expenditures (PCE) deflator, also surged, to 4.0% in the fourth quarter, twice the Fed's 2.0% target.

We expect pricing pressure to moderate later in 2022, though we don't expect core PCE inflation to reach the Fed's average 2.0% inflation target until late 2023. After the Fed tapers bond purchases to zero in 2022, we expect it will raise rates, for the first time since the pandemic, at its September meeting, followed by three more hikes in 2023 and another two in 2024. The risk is for even tighter Fed policy.

However, minutes from the November Federal Open Market Committee (FOMC) meeting highlight "increased uncertainty," with "many participants" noting that "elevated inflation could prove more persistent." With that in mind, we now believe that the Fed will speed up tapering in first-quarter 2022 to $25 billion a month, reaching zero three months earlier than it's indicating. This would give the Fed room to raise the federal funds rate even sooner than dot plots currently indicate.

Table 1

Overall, the U.S. economy is resilient over the near term, but government bickering over infrastructure proposals and the threat of a government shutdown or, more ominously, a debt ceiling crisis can't be ignored.

Labor Force Exit Constrains The Job Market

The U.S. job market picked up in October, as the impact from the delta variant faded, and added 531,000 jobs--the most since July and above consensus expectations. The unemployment rate edged down to 4.6% from 4.8%.

But the labor force participation rate being stuck at 61.6%, a 45-year low and not much better than the pandemic 48-year low of 60.2, clouds the improvement in the labor market. Accounting for all the people who left the workforce since February 2020, the unemployment rate is 6.4%. The labor force remains 3 million below its February 2020 level, according to the Bureau of Labor Statistics, with employment gains largely due to flows from unemployment into employment rather than gains from workers returning to the labor force. With labor force exits accounting for 64% of the 4.5 million people who left the workforce, these enormous job market constraints are crippling business capacity, resulting in much lower economic activity than would be the case if business operations were running smoothly.

The bigger question is whether the 3 million who left the workforce entirely since the pandemic will return. That depends on how much of the drop is structural and how much is temporary. We estimate that about 42% of the 3 million people who left the workforce since February 2020 are permanent, largely tied to retirement, while 58% are shorter-term, pandemic-specific decisions to leave the market (see "Labor Force Exit Has The U.S. Economy In A Bind"). The non-age component has a greater chance of recouping some of the shortfall. Less fearful workers will return to cities--some already have. But the location mismatch remains a problem. Based on Google trends data, a person's commute to work is still 20% further than in 2019, before the crisis.

As people, particularly young parents, eventually feel that the virus has been defeated, they likely will return to work. Prime-age workers (ages 25-54) account for 1.4 million, or 45%, of the 3 million people who exited the labor force. Women account for 68% of that 1.4 million. Child care concerns and virus fears for their unvaccinated children under 5 are likely the main factors keeping them out of the jobs market. The return of prime-wage workers is key to stabilizing the jobs market. We expect that many of these workers could decide to reenter the workforce, but not until pandemic-related issues are resolved. Retirees account for a smaller share of the 3 million people who exited the labor force since February 2020, though their relative participation rate has dropped a massive 8.1 percentage points, over 5x that of prime-age workers.

Among those who are sitting on the sidelines temporarily, how soon they return is still an unknown. A larger labor force means higher labor productivity, which helps determine the path of U.S. economic growth and inflation, as well as the Fed's policy decisions in 2022 and beyond. But with fewer people in the labor force than would be expected given the state of the economy, the labor market is less recovered than the unemployment rate would suggest.

Some of these factors should improve as the pandemic recedes while others may take longer to resolve. The employment-to-population ratio ticked up to 58.8%, largely reflecting increases in employment among prime-age workers and those aged 16-24. Employment of the 55 and over age group has recovered the least, partly reflecting the increase in retirements during the pandemic. Regardless, returning to the pre-pandemic path is going to require labor force participation rates to improve.

Willing To Spend More On Holiday Cheer

Consumer spending data indicates that people are willing to pay a premium for a happy holiday season. October retail sales rose 1.7% month over month, following a 0.8% gain in September, reflecting a persistent surge in household demand, in part as the pandemic recedes in the U.S., as well as an early start to holiday shopping, to grab presents before the shelves are empty.

According to the Opportunity Insights Economic Tracker data for the week ended Nov. 7, consumer credit and debit card spending was 28.2% above the January 2020 level for high-income and 32.1% for low-income households, pointing to another solid month for retail and food services sales, in part because of higher prices. But, controlling for inflation, fourth-quarter consumer spending is still up 4.6%. We expect real consumer spending to surge by 8.0% for the year, a record percentage gain going back to 1948.

However, surging inflation continues to erode consumer confidence, as the latest University of Michigan Consumer Sentiment Index reading hit its lowest level in the past 10 years. Consumers registered disappointment both today, and in the future, with current conditions falling to a 10-year low while expectations dropped to an eight-year low. A more current real-time reading based on the Ipsos-Forbes Advisor Consumer Confidence Tracker shows signs of moderate improvement, gaining another 2.3 points to 57.7 for the week ended Nov. 18, though well below its July 1 high of 62.4, as inflation pressures and virus worries still weigh on moods. The jobs subindex continued to improve, gaining 3.8 points, while the Ipsos expectations component also picked up in the Nov. 18 week, though by a much more modest pace. Higher prices at the checkout largely explain the disappointment in the Michigan survey, with the one-year inflation gauge hitting a 13-year high and the five- to 10-year inflation reading holding close to its recent high seen in September.

Easing Supply Constraints

Our lower GDP forecast, if correct, is still the highest reading since 1984. And with a stimulus-driven surge in demand outpacing supply gains, inflation is running at breakneck speed. However, there are signs inflation is starting to ease (slightly) as supply bottlenecks unjam, higher prices weaken demand, and base effects start to wear off.

While bottlenecks remain across the supply chain and are keeping the real-time indicators we watch regularly at high levels, already there are signs of alleviation in construction and manufacturing. Lumber prices are around $797 per 1,000 board feet on Nov. 19, 53% below their May 7 high of $1,686, on a mix of cooling home demand and replenishment of home inventories. Even the CMCI Industrial Metals Price Index is 5.4% below its Oct. 15 high, though it remains 47% above its 2019 average, highlighting how out of whack demand-supply conditions are today. The Baltic Exchange Dry Index (BDI) also declined, by 55% as of Nov. 19, 2021, from its record high in October, and near its lowest level since the start of the pandemic. Recognizing that the BDI can experience significant volatility, the significant drop does suggest that bottlenecks in the global transportation network are improving.

On the manufacturing front, the Taiwan Manufacturing Purchasing Managers' Index of backlog of orders fell to 50.3 as of October from a peak of 71.5 in April, signaling that semiconductor production capacity is improving relative to strong global demand. The Industrial Metal Price Index also hovered around 1,535 in early November, which is still high though 10% lower than the near-term peak in mid-October. That said, all these production indicators are above pre-pandemic levels and still signal sustained inflationary pressures.

Not So Transitory?

We continue to expect pricing pressure to slowly ease in 2022, but only reach the Fed's flexible average inflation target by second-half 2023. Both the slow easing of labor supply constraints, as pandemic fears subside and more people get vaccinated (and rejoin the workforce), and tighter monetary policy will likely cap slow price increases later in 2022. Moreover, negative real wages squeezing household purchasing power will also help moderate inflation. Once bond purchases reach zero, we expect the Fed's first interest rate hike to come in September 2022. But the longer people sit on the sidelines, job market pressure on wages could force the Fed to move faster than it currently expects.

While minutes from the November FOMC meeting indicated that participants "generally" anticipate that "the inflation rate would dimmish significantly in 2022," they noted "increased uncertainty" to this assessment, with "many participants" pointing to factors that "might suggest that elevated inflation could prove more persistent." With that said, the Fed seems more prone to speed up tightening sooner than expected. After the Fed reduces purchases by $15 billion a month, it seems prone to speed up tapering, possibly to $25 billion a month, reaching zero three months earlier than it currently indicates. This would give the Fed room to raise the federal funds rate sooner in 2022--maybe even sooner than our current forecast for a September hike.

The Fed could also be forced to move quickly to contain elevated inflation in 2022 if price gains prove not to be "largely transitory." The Fed's even tighter monetary policy will eventually tame price readings, but not without economic growth slowing as well. How sharp a slowdown depends on how big an inflation battle the Fed must fight.

While inflation has picked up in fourth-quarter 2021, with CPI likely to reach 5.9%, it moderated from its 30-year high of 7.9% in the second quarter. CPI inflation is expected to soften only modestly next year, as high prices will persist through 2022, with the annual rate slowing to 3.9%, still almost twice the Fed's average inflation target of 2.0%. Although core CPI inflation reached a 30-year high on an annual basis, momentum has slowed, with the three-month moving average still below its 40-year high in the second quarter (see chart 2). Core inflation is expected reach 4.9% in the first quarter of 2022, though down from its 40-year high of 7.9% in second-quarter 2021.

Chart 2

On further easing of supply bottlenecks and Fed tightening, we expect that inflation will slow to 2.6% in 2023. The core PCE deflator, which runs about 25 basis points to 30 basis points cooler than CPI, will slow to around 2.8% and 2.1% for 2022 and 2023, respectively. The core PCE deflator will not near the Fed's 2% target until late 2023.

While everyone feels the pain of higher prices, lower-income households are hit harder by higher prices than higher-income households. Higher gasoline prices dent household purchasing power overall. But when comparing the impact of higher gasoline prices on purchasing power, it's important to consider that spending on energy as a percentage of disposable income for low-income households is about 5x that of high-income households.

Demographic details indicate that inflation is more of a headwind to consumer spending than the aggregate data suggests. Although excess savings from fiscal support during the pandemic should cushion the inflation shock, the question is whether consumers treat these savings as income or wealth. Historical data suggests consumers spend about 70 cents to the dollar of excess income but just four cents to a dollar of excess wealth. With real income declining, we think the risk is that consumers will be cautious and treat a portion of their excess savings as wealth. This is good for the long-term health of their balance sheets but a concern for the near-term growth outlook.

A much tighter-than-expected monetary policy could also exacerbate income inequality in 2022. The Fed indicated in 2020 that it would broaden its job market scope beyond targeting just the national unemployment rate, which tracks closely with the white unemployment rate, to include job market conditions for other demographics. The unemployment rate for Black and Hispanic Americans is at 7.9% and 5.9%, respectively, well above the 4.6% national rate and 4.0% for white Americans, suggesting the Fed's mission is not complete. But if high inflation persists, the Fed could be forced to respond--and tighten monetary policy--before other demographics, such as Black and Hispanic Americans, fully experience the benefits of a healthy economic recovery on job prospects.

Financial Conditions Improved In The Second Quarter To A 10.5-Year Low

Timely public policy responses have improved financial conditions for the U.S. nonfinancial private sector, according to our Financial Fragility Index. The overall index went down to -2.12 in the second quarter (the lowest rate in 10.5 years) from -1.53 in the first (see chart 3). Both subindices for households and firms were down at the same time. The improved financial conditions of borrowers may have boosted the confidence of financial markets, with the Chicago Fed National Financial Conditions Index going down in tandem, to -0.71, on average, in the second quarter from -0.63 in the first, also remaining lower than the historical average of zero.

Still, corporate debt levels are high, with a significant amount speculative grade. While bond payments are largely easy to manage, with the economy on fire and interest rates currently at record lows, when rates go up and the economy slows, many businesses may be singing a different tune.

For households, lower leverage amid stable liquidity risk and wealth effects drove the household index down to -2.47 from -1.98. Specifically, lower year-over-year growth in charge-off rates (the value of loans and leases removed from the books) was the major factor behind lower leverage, although the debt service ratio and debt-to-income ratio rose faster as personal income edged down while consumer credit grew in the second quarter. For firms, the index also went down, to -1.77 in the second quarter from -1.32 in the first quarter, with liquidity risks declining substantially and leverage risks edging up. The strong balance sheets of households and firms set the stage for further expansion of the U.S. economy.

Chart 3

Government Policy And Infrastructure Packages: What Do They Mean?

As stimulus checks work their way through the system, several infrastructure packages are being tossed about on Capitol Hill. On Nov. 15, President Biden signed into law the bipartisan $1 trillion infrastructure package (about $550 billion in new funds). With the ink still wet, the administration is looking to pass its 10-year Build Back Better infrastructure plan, to further strengthen the U.S. economy in later years. While democratic lawmakers are negotiating the size, with two of the party's senators baulking at the price tag, we suspect that Build Back Better (BBB) will make it to law. We expect the BBB plan to be approved, with a price tag of about $8 trillion, half the $3.5 trillion the president originally proposed. Given BBB outlays spread out over a 10-year period, unlike the $5.5 trillion in COVID-19 stimulus measures that were spread out over 18 months, the inflationary impact will be more modest. There is some movement toward a debt-neutral infrastructure plan, unlike the COVID-19 stimulus measures that were put in place.

How projects are financed plays into the overall long-term impact on the economy (debt-financing will likely put upward pressure on interest rates in later years, weighing on costs). But, infrastructure investment, if done wisely (meaning no bridges to nowhere), would benefit the economy. That said, the Congressional Budget Office notes in its August 2021 report on physical infrastructure that deficit financing would mitigate the positive effects on the economy of investments in infrastructure.

We recently updated our projections on the impact a hypothetical $1 trillion infrastructure investment would have on the U.S. economy through 2030 (see "How U.S. Infrastructure Investment Would Boost Jobs, Productivity, And The Economy," Aug. 23, 2021). We estimate a 1.4x multiplier, meaning a $1 trillion infrastructure investment would add $1.4 trillion to the economy over the project's duration. This assumes that supply bottlenecks ease when the shovels hit the ground. We also found a project of this size would create 883,600 jobs by 2030, many of them middle class, and per capita income would be 10.5% larger than in the no infrastructure scenario. Private-sector productivity would also get a roughly 10-basis-point boost from the infrastructure investment each year. That productivity boost would likely lift average GDP growth on an annual basis to 2.1% from around 2.0% over the project period.

Shutdown And Debt Ceiling

Congress faces two enormous tasks over the next month: funding the U.S. government or face a government shutdown and increasing the debt ceiling. If no agreement is reached to fund the government by Dec. 3, the federal government will be closed until further notice. Even worse, Treasury Secretary Janet Yellen has warned that extraordinary measures to avoid broaching the debt limit are likely to run out by Dec. 15.

The shutdown, if it's brief, wouldn't be a disaster, but would still reduce some of the economic gains the U.S. has felt from the reopening, and add more complications to a system already tangled up by supply-chain disruptions. S&P Global Economics estimates the U.S. government shutdown may cost fourth-quarter growth around $1.8 billion (annualized), or 0.11 percentage points, for every week the government is closed, on both direct and indirect costs.

While some indirect costs (such as canceled trips to closed national parks) may be regained once the government reopens, the productivity lost from direct costs (furloughed "nonessential" government workers) would reduce real GDP--since no "product" was created--and would never be regained. However, furloughed government employees do usually get paid (with taxpayer money, assuming Congress decides to compensate them afterward, as has been the case in the past). The shutdown would have no effect on nominal GDP and would, instead, add to fourth-quarter inflation. With inflation currently skyrocketing, the Fed will have another headache to contend with.

Upside And Downside Scenarios

Each quarter, S&P Global Economics projects two scenarios in addition to the base case, one with faster growth than the baseline and one with slower (see chart 4). In this report, the scenarios are based on risks to baseline growth coming from the timing of vaccine availability to the wider public, strength and duration of capacity restrictions, and amount of further fiscal support.

Chart 4

Table 2

Upside

In our upside scenario, the $1.9 trillion stimulus-driven recovery, together with a massive vaccine push, allows the U.S. to reach herd immunity a little sooner than earlier thought. Households, itching to go out and celebrate with friends and family, dip into their savings accounts to splurge on the leisure activities they have neglected for most of the year. Holiday spending jumps as the U.S. aims to make this long overdue celebration a monumental one. Consumer spending surges to a post-World War II high of 8.3% in 2021 and 4.9% the following year, above the 8.0% and 3.8%, respectively, in the baseline.

As future economic conditions continue to suggest happy days and more revenue in store, businesses readily open their bank accounts. Equipment spending surges by 13.4% this year and 4.0% next year, with relative gains over the baseline increasing in 2022 as confidence improves. In the upside scenario, the U.S. economy rebounds 5.8% in 2021 and continues to grow at a higher pace of 4.5% in 2022 (versus 5.5% and 3.9% in our baseline, respectively).

Higher growth rates also mean the unemployment rate falls under 4% by mid-2022. Moreover, the labor force participation rate continues to rise, bringing in folks from the sidelines as worries over COVID-19 moderate as more people are vaccinated. Core CPI inflation (actual and expectations) starts slowing midway through next year, proving the current supply shock to be transitory and giving the Fed more room to wait before it raises the policy rate. After letting the economy run hot for longer, the Fed raises its policy rate for the first time in this recovery in late 2022 (in line with the baseline).

There is a 15% chance of this scenario happening.

Table 3

Downside

In our downside scenario, the U.S economy continues to suffer persistent shortages of labor and goods. U.S. economic growth slows to 5.4% in 2021 and 2.8% in 2022. While the economy does not suffer a recession in our downside scenario, growth is much slower than the 5.5% and 3.9% for this year and next, respectively, expected in our baseline.

The Fed gets behind the curve, losing control of inflation and inflation expectations. Price inflation of 4% or more lasts longer, and growth in real disposable income weakens, crimping real demand growth. As a result, producer prices are even higher and harder to pass on to consumers, leading to a deterioration in corporate profits, which triggers a pullback in the S&P 500 that causes a decline in the wealth effect, weakening overall domestic demand. GDP growth clocks in at 5.4% and 3.4% in 2021 and 2022, respectively.

Recognizing that it misjudged inflation dynamics, the Fed has to raise rates earlier and faster than currently expected in our baseline, hiking rates three times in 2022. Interest rate-sensitive sectors slow down immediately, with residential investment falling by 5.4% in 2022, double the 2.8% drop in the baseline. Residential investment falls a further 1.1% in 2023, while the sector recovers 0.6% in the baseline. Nonresidential construction, still hurting from the pandemic-related damage to commercial real estate, falls by 8.0% and 2.0% this year and next, respectively, much larger than a 7.9% drop and 0.6% gain in 2021 and 2022.

Although the Fed hikes earlier in this scenario (versus the baseline), the shock to the economy leads the Fed to take its foot off the petal, with no rate hikes the following year. Interest rate increases lag the baseline by 0.3 percentage points in fourth-quarter 2023. The economic slowdown causes the Fed to cut rates one time in 2024. In contrast, the Fed raises rates two more times in 2024 in the baseline. Inflation remains elevated until the second half of 2023. Inflation does start to stabilize as the supply side wrinkle finally irons out by mid-2024, but demand has also dropped enough by that time that the Fed chooses to slow its rate hike cycle.

In this scenario, job growth slows (compared with the baseline) by early 2022, with the unemployment rate stalling at 4.2% in 2022 and 4.1% in 2023, not reaching its pre-pandemic low until sometime in 2024. In contrast, the job market heals at a quicker pace in the baseline, with the unemployment rate reaching its pre-pandemic low by first-quarter 2023. The government's infrastructure package, spread out over eight years, helps, but it is not designed to prop up short-term demand (like transfer payments and boosters to unemployment benefits), so the overall cyclical expansion becomes weaker than in the baseline.

There is a 25% chance of this scenario happening.

Chart 5

Table 4