U.S. economic activity remained largely healthy through early March, based on our real-time indicators. Omicron infection rates subsided and restrictions were removed, allowing more people to get outside and spend. While COVID-19 appears to be in the rearview mirror (for now), the Russia-Ukraine conflict worsens already troubling pricing pressures tied to continued supply-chain disruptions. The impact on the U.S. economy is relatively moderate when compared to the pain felt in countries closer to the center of the storm, but ramifications are still noticeable.

Chart 1

We expect the economic damage to lower U.S. GDP growth to 3.2% this year, matching our preliminary forecast in early March but a full 70 bps lower than our November forecast of 3.9%. The main drivers for weaker than expected growth this year and the next are continued supply chain disruptions, exacerbated by the Russia-Ukraine conflict; higher prices, particularly for food and energy; and much more aggressive Fed policy to fight these higher prices. Direct linkages with Russia are small (even smaller for Ukraine) and U.S. trade with Russia is concentrated in a few areas. U.S. exports to Russia are concentrated in machinery, aircraft, and vehicles, for example, while imports from Russia are concentrated in energy, metals, and fertilizer (see charts 1 and 2).

Chart 2

Chart 3

We now expect seven rate hikes this year, with the Fed reducing the size of the balance sheet starting in May, and four to five the following year, pushed forward as the Fed tries to frontload rate increases to stamp out elevated inflation. We expect a 50-bp hike as soon as May, with more 50-bp rate hikes an increased possibility.

Already weakened, we see consumer confidence worsening in 2022 as conflict-driven higher prices weigh further on household purchasing power and stock prices weakening as investors move to safe-haven assets. With purchasing power squeezed, household spending will slow considerably. This squeeze was already a factor in 2021, given high inflation. The Russia-Ukraine conflict made it worse.

That said, recognizing the extreme uncertainty around the conflict, we assume it will remain contained both in intensity and geography and will be limited in length (we assume two quarters of military conflict with sanctions largely to remain in place long after it has ended). There are reasons to believe the U.S. will be able to absorb the hit without sinking into recession, including still relatively healthy balance sheets for the private sector to cushion higher prices at the checkout stand and an economy that is largely driven by domestic activity--another layer of insulation from the conflict.

Direct linkages with Russia and Ukraine through trade and financial channels are also small. From 2010 to 2019, average U.S. imports from Russia represent only 1% of total U.S. imports. U.S. exports to Russia are just 0.5% of total U.S. exports. Cross-border flows are also small, accounting for 0.33% of total claims U.S. banks have on foreign entities. Direct linkages with Ukraine in these categories are even smaller. Moreover, the U.S. is also now a top producer of energy and other commodities, such as wheat, allowing the U.S. to benefit from trade substitutions away from Russia and Ukraine.

Chart 4

While our baseline forecasts a moderate slowdown this year and the next, we recognize the large uncertainty around this outlook, particularly to the downside. Increasing uncertainty around the Russia-Ukraine conflict would make our economic outlook that much worse. Our downside scenario at the end of this report considers the effects of more extreme bottlenecks on prices and Fed policy. In this scenario, 2023 GDP growth at 1.4% is considerably slower than our baseline GDP forecast of 2.1%.

We assess the risk of recession in the next 12 months as about 1-in-4 (and less likely before 2023, as successive rate hikes take effect). Given heightened uncertainty, we're setting the range at 20%-30%.

The Retail Honeymoon Is Canceled

Inflation continued to climb after jumping in fourth-quarter 2021, when various price indicators reached multidecade highs. The February Consumer Price Index (CPI) surged by 7.9% year-over-year, up from its 30-year high of 7.5% in January. Core inflation jumped to 6.4% y/y in February from 6.0% in January. Headline and core CPI are at their highest since 1982, with the core rate now over 3x the Fed's target of 2.0%. The Fed's preferred inflation indicator, the core Personal Consumption Expenditures (PCE) deflator, surged to 5.2% in January--over 2.5x the Fed's 2.0% target. Core PCE is expected to moderate this year, reaching 3.2% y/y in the fourth quarter, more than 1.5x higher than the Fed's target. Continued aggressive tightening next year, along with an easing of supply constraints, will push core PCE below the Fed's target in 2024. As a result, we expect the Fed to cut rates in 2024.

Our real-time price measures rose through mid-March, with only lumber prices still below their record high from May 7, 2021. Average hourly wages were flat for the month, moderating year-over-year wage gains to a still-large 5.1% in February, from 5.5% the month before. In real terms, wage gains remain negative, squeezing household purchasing power.

Even more concerning for the Fed, there are strong signals that higher prices may persist. Various long-term inflation expectations readings appear to be at new highs. University of Michigan inflation expectations one year and five years ahead are at respective 14-year and 11-year highs while 10-year forward inflation expectations hit a record high--all reason for the Fed to let its interest rate policy rocket fly high through the year.

We expect pricing pressure to remain elevated through 2022, with core PCE inflation reaching the Fed's average 2.0% inflation target in 2023. The Fed has initiated lift-off with a 25-bp hike in March and aims to aggressively raise rates this year and the next, with seven rate hikes this year, including a 50-bp hike, and at least four more in 2023. The risk is for even tighter Fed policy.

Table 1

The People Left Behind

While everyone feels the pain of higher prices, lower-income households are hit harder by higher prices. For instance, higher gasoline prices dent household purchasing power overall, but spending on energy as a percentage of disposable income for low-income households is about 5x that of high-income households.

Fortunately, the combination of hefty stimulus packages targeting lower-income households, an extremely tight jobs market lifting wages, a strong stock market supporting higher-income households, and low interest rates reducing borrowing costs have helped cushion household balance sheets. Average U.S. household savings remain almost $2.5 trillion over the 2019 average. Moreover, U.S. household net worth in fourth-quarter 2021, at $142 billion, is at an all-time high. While higher income household saw the largest gains, net worth across all income brackets is higher than 2019 pre-crisis levels.

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Chart 6

Still, four-decade-high price readings will erode that buffer eventually if prices remain high. The buffer is also smaller at the low end of the income spectrum.

Demographic details indicate 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 the 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.

Much tighter-than-expected monetary policy could also exacerbate income inequality this year and the next. The Fed indicated in 2020 that it would broaden its job market metrics beyond targeting just the national unemployment rate, which tracks closely with the white unemployment rate, to include job market conditions for other demographics. But with persistent high inflation, the Fed has been 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.

Chart 7

Chart 8

Labor Force Exits Continue To Constrain The Job Market

As omicron variant cases decline, February payrolls climbed 678,000 for the month, with a net 92,000 gain over the prior two months. The unemployment rate fell to 3.8%, from 4.0% in January, for all the right reasons. 304,000 people entered (or reentered) the work force and 548,000 workers got a job. Moreover, labor conditions remained strong well into March, with initial jobless claims for the week ended March 19 down by 28,000 from the previous week to 187,000. This marks the lowest level since 1969 as COVID-19 cases declined amid tight market conditions. Strong job gains with surging prices gave the Fed reason to raise rates by 25 bps in March.

As the omicron variant subsided in February, workers were able to return to work after apparently being forced to take time off to recover or take care of loved ones in January. Hours worked rose by 1 bp to 34.7 hours after falling 2 bps to 34.6 hours in January (revised from 34.5 hours in January). But with the labor participation rate (LPR) at a 45-year low, supply remains tight. We expect the LPR to trend higher, though still uncomfortably low.

Limited supply means higher paychecks for the foreseeable future. The Atlanta Fed reported that overall wage gains reached a record high in February (see chart 9). Worker paychecks saw flat average hourly wages for the month, moderating year-over-year wage gains to a still-large 5.1%, from 5.5% in January, according to the Bureau of Labor Statistics (see chart 10). Unfortunately, higher overall price gains will likely take a bite out of paychecks. With the CPI at 7.9% y/y in February, real wage growth remained negative, as we expect it will through most of the year.

Chart 9

Chart 10

The healthy jobs market, together with inflation readings reaching multidecade highs, puts the Fed on solid ground to raise rates. How high the Fed policy rocket will fly depends on inflation dynamics and the economic fallout from the Russia-Ukraine conflict. While conditions surrounding the conflict are extremely uncertain and kept the Fed rather tame in March with a 25-bp hike, Fed Chair Jerome Powell already indicated that 50 bps is on the table as soon as May.

Although the labor market is strong, the labor force participation rate was around 62.3%, remaining around its 45-year low and not much better than the pandemic 48-year low of 60.2%. Of the 1.5 million workers who have left the labor force since February 2020, many are prime-age (25-54), often women. Although the relative participation rate of retirees has dropped dramatically, they account for a smaller share of the overall labor exits since February 2020.

With prime-age labor force exits accounting for 71% of the 2.1 million people not working since February 2020, the 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 return of prime-wage workers is key to stabilizing the jobs market. As people, particularly young parents, eventually feel that the virus has been defeated, we expect many will return to work. We believe child care concerns and virus fears for their unvaccinated children under 5 are likely the main factors keeping them out of the labor market.

The Fed expects (or hopes) that workers will return as the U.S. returns to a post-COVID-19 state, softening supply constraints and taming wages. 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.

We believe some aspects of the labor market should improve as the pandemic recedes, while others may take longer to resolve. Regardless, returning to the pre-pandemic path is going to require labor force participation rates to improve.

Coming Out Fighting

As we expected, when price gains proved not to be "largely transitory," the Fed announced aggressive moves to contain elevated inflation. The Fed's tighter monetary policy will eventually tame price readings, but not without slowing economic growth as well. How sharp the slowdown in GDP will be depends on how big an inflation battle the Fed must fight.

As the military conflict worsens supply chain disruptions, we expect CPI inflation to soften only modestly this year, with the annual PCE core rate moderating to 3.2%, still over 1.5x the Fed's average inflation target of 2.0%. We expect price momentum to slow into next year, on the delayed effect from tighter Fed policy. We expect core inflation to moderate to 2.0% in the first quarter of 2023, though continued Fed tightening will likely push prices lower into 2024 and below its target of 2.0%. Concern that the economy may be heading back to persistent low inflation will give the Fed reason to lower rates and bring the fed funds rate closer to its neutral rate by year-end 2024.

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. 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.

Table 2

Upside

In our upside scenario, a ceasefire and faster resolution to the military conflict between Russia and Ukraine leads to softening inflation as commodity prices stabilize, allowing the Fed to slow monetary tightening. No longer focused on the conflict, the U.S. government increases infrastructure spending.

The U.S. government turns its attention to the Build Back Better infrastructure package, which, together with the bipartisan package, supports economic activity through 2026. Households celebrate lower prices at the gas pump by traveling to see friends and family and dipping into their savings accounts to splurge on leisure activities. Consumer spending increases to 3.7% in 2022, after reaching a post-World War II high of 7.9% in 2021, and 2.5% in 2023, above 3.3% and 2.2%, 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 6.4% this year and 3.2% next year, stronger than 5.3% and 2.8% in the baseline, as confidence improves. In the upside scenario, the U.S. economy grows by 3.6% in 2022 (versus 3.2% in our baseline) after surging to a 37-year high in 2021.

Higher growth rates also mean the unemployment rate falls under 3.5% by the second half of 2022. Moreover, the labor force participation rate continues to rise, bringing in folks from the sidelines as worries over COVID-19 moderate and more people are vaccinated.

Stabilizing supply chains and calming energy and commodity prices give the Fed reason to raise rates gradually, with the federal funds rate reaching 1.75%-2.00% by 2023, 1 percentage point lower than in the baseline. The Fed slowly raises rates until it reaches the federal funds rate's neutral rate by third-quarter 2024. If the current supply shock proves to be transitory, core CPI inflation (actual and expectations) starts slowing midway through next year, giving the Fed more room to take a gradual approach to monetary policy.

Table 3

Downside

In our downside scenario, the U.S economy continues to suffer higher prices and persistent shortages of labor and goods, further exacerbated by the Russia-Ukraine conflict and continued sanctions long after its end. This forces the Fed to turn the knob on higher rates, slowing growth considerably next year.

Oil prices climb to over $120 a barrel while prices for food and other commodities climb higher, pinching consumer pocketbooks this year. U.S. economic growth slows moderately, to 3.1% in 2022. As cumulative Fed rate hikes take hold, growth slower further, to 1.6% in 2023. While the economy does not suffer two quarters of negative growth in our downside scenario, growth slows sharply compared to 3.2% and 2.1% in our baseline.

After showing signs of improvement, supply chain disruptions would worsen, weighing on economic activity and keeping prices, both overall and excluding food and fuel, elevated in 2022. This forces the Fed to tighten policy more dramatically than the 11 rate hikes they currently indicate through 2023, 1.5 percentage points higher than our baseline, with 50-bp hikes the norm this year and in the first half of 2023.

The Fed's attempts to stomp out inflation are not enough and they lose 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. This triggers a 4% pullback in the S&P 500 in 2022 with no gains the following year. That causes a decline in the wealth effect, weakening overall domestic demand.

Interest rate-sensitive sectors slow immediately, with residential investment falling by 0.8% in 2022, double the 0.4% drop in the baseline. Residential investment falls a further 0.5% in 2023, while the sector recovers 0.1% in the baseline.

The economic slowdown causes the Fed to cut rates by 100 bps in 2024, compared to one cut in 2024 in our baseline. Inflation remains elevated until prices start to slow below their 2.0% target. By 2024, the Fed realizes low inflation is the greater concern and begins to lower rates. The Fed continues to cut rates until the federal funds rate reaches its neutral rate by second-quarter 2025.

Table 4