Economic Perspectives January 2022

• As we turn into the new year, the path of the pandemic continues to shape the macroeconomic landscape, highlighted by the latest emergence of the Omicron variant. We maintain the view that Omicron will not derail the economic recovery, which remains nonetheless affected by other headwinds, such as persistent supply chain bottlenecks and soaring energy prices. Overall, our assessment of the economic outlook remains positive, though subject to considerable downside risks. That said, we expect another year of robust, albeit sequentially lower, annual growth rates across major economies.
• The euro area economy appears to have ended the last year on a soft note, with activity weighed down by another pandemic wave and widespread supply bottlenecks. We expect the lukewarm activity seen in Q4 2021 to extend into the first quarter of 2022. After challenging winter months, we forecast that growth will strengthen to a strong (and above potential) pace, and solid momentum will continue into 2023. In year-on-year terms, real GDP growth in the euro area is expected to moderate to 3.5% in 2022 and 2.4% in 2023, after 5.1% last year.
• The recent activity data in the US suggest that the economy re-accelerated to a solid pace heading into the new year. Despite the rapid spread of Omicron, the US economy is well positioned for sustained momentum over the winter months. Sequentially lower economic growth thereafter will mostly reflect a normalisation in the growth pattern towards a more sustainable pace as the pandemic-related catch-up effects dissipate. Overall, we expect the US economy to expand by a healthy 3.6% in 2022 and a still respectable 2.3% in 2023, from 5.6% last year.
• 2022 will once again be a balancing act for Chinese policymakers straddling the objectives of prioritising growth and addressing risks in the economy. Besides risks stemming from the real estate sector, Covid developments present an important uncertainty for the economic outlook given the government’s strict ‘zero-covid’ policy. Chinese policymakers have recently communicated a policy shift toward stabilising growth, particularly through moderately easier monetary and fiscal policy. This should help year-over-year growth figures recover toward 5%, leading to 2022 annual growth of 5.1%.
• Inflationary pressures accelerated sharply towards the end of 2021, with inflation readings at multi-decade highs in the US and the euro area, driven by several pandemic-related factors. We maintain the view that most of these factors are unlikely to create lasting price pressures. As we move through 2022, inflation should, therefore, gradually moderate from currently elevated levels, assuming a stabilisation in energy prices and some alleviation in global supply bottlenecks. Admittedly, the inflation outlook remains subject to considerable uncertainty and near-term upside risks.
• At the December policy meeting, the Fed signalled a hawkish pivot towards faster monetary policy normalisation. The FOMC decided to double the pace of tapering, which is now expected to end in March, opening the door for a first rate hike in the same month. In total, we pencil in four 25 bps rate hikes for 2022, followed by another three 25 bps hikes in 2023. Meanwhile, the ECB announced the end of net purchases under the Pandemic Emergency Purchase Programme in March, but interest rate lift-off appears unlikely this year. Our baseline forecast assumes one 25 bps hike in the refinancing rate in 2023, together with raising the deposit rate from negative territory.

As we move into year three of the pandemic, the world is still reeling with the effects of Covid-19. The past year was marked by important steps towards the normalisation of socio-economic life, helped by the rapid rollout of vaccination campaigns and the lifting of mobility restrictions in many parts of the world. Still, despite substantial progress in keeping the virus more under control, the path of the pandemic continues to shape the macroeconomic landscape, highlighted by the latest emergence of the Omicron variant, which increases the risks and uncertainty around the economic outlook in 2022.

The Omicron variant: is this time different?

The year 2022 started with yet another Covid-19 wave across the globe, triggered by the new Omicron variant which is associated with markedly greater transmissibility. As a result, the global case count is now well above the Delta peak from summer 2021 with record-high infection rates in the US and Europe (figure 1). On a positive note, available evidence suggests that the link between cases and severe disease has weakened materially with Omicron. That is to say, the Omicron variant appears to cause less severe illness than previous strains, and while it evades vaccine-induced immunity more easily than Delta, existing vaccines remain effective with a booster, in particular against severe cases.

We have, therefore, maintained the view that Omicron will not derail the economic recovery. In the absence of full lockdowns, absenteeism (due to illness or quarantine) and the size of the behavioural shift towards caution will largely determine the drag on economic activity from Omicron. Importantly, activity has now become less sensitive to virus spread due to medical advances, implying a more limited dampening effect than earlier in the pandemic. Moreover, there are good reasons to believe that the link between the pandemic and economic activity will be weakened further this year, should we see the evolution toward endemic (and less virulent) seasonal Covid-19 waves.

Supply chain disruptions: starting to moderate?

The near-term growth picture remains also affected by persistent supply chain bottlenecks which have become a major challenge for the global economy since the outbreak of Covid-19. Against a backdrop of strong goods demand, global supply is slow to catch up due to factory shutdowns, shortages of key components and logistical bottlenecks, leading to weaker growth impulses and stronger inflationary pressures.

There are some tentative signs that supply chain disruptions have peaked, highlighted by the new Global Supply Chain Pressure Index published by the New York Federal Reserve (figure 2). In addition, the latest PMI data across major economies, namely the ‘delivery times’ subcomponent, indicate that supply constraints have eased on margin. Similarly, the Baltic Dry Index, which reflects shipping costs for bulk commodities, has declined sharply in recent months.

All this data nonetheless suggest that supply chain disruptions are still unprecedented from a historical perspective, and it will likely take some time for supply conditions to fully normalise. Supply bottlenecks are, therefore, likely to weigh on activity over the coming quarters, despite our assumption of a gradual unwinding in the course of 2022. At the same time, supply chains remain vulnerable to pandemic-related restrictions, and we see a considerable downside risk from the spread of Omicron in Asia, where some of the key manufacturing hubs are located. In particular, China’s zero-tolerance policy, together with doubts over the effectiveness of the Chinese-made vaccines, raises the risk of negative spillovers to other regions of the world economy, potentially leading to longer – if not more intensified – supply chain disruptions.

Europe’s energy crisis: what next?

Along with supply chain disruptions, Europe has witnessed a surge in natural gas prices (boosting wholesale and retail electricity prices), putting pressure on households’ purchasing power and headline inflation during the winter months. In December, the Dutch TTF natural gas futures soared to a record high of EUR 183 per megawatt hour on the back of tight natural gas inventories (figure 3). Though still elevated, prices have declined markedly since then, helped by increased supplies of liquefied natural gas (LNG) to Europe. With inventories at unusually low levels, European gas prices are set to remain exposed to large swings and driven by volatile factors such as weather conditions and geopolitical tensions.

Euro area: winter sluggishness

The euro area economy appears to have ended the last year on a soft note, with activity weighed down by another pandemic wave and widespread supply bottlenecks. Still, the latest batch of hard data suggests a continued resilience of the euro area economy. In November, retail sales surprised to the upside and increased by 1.0% mom, indicating that consumer demand held up well heading into year-end. Meanwhile, industrial production in the euro area expanded by a healthy 1.1% mom in October, though this might reflect volatility in the data series more than the beginning of a new uptrend.

Looking ahead, we assume that growing pressure on the healthcare systems will be manageable, implying that ongoing policy measures are only temporary, and will not escalate into full-blown lockdowns (the Netherlands and Austria remain the exception). However, the recent pandemic wave, together with a surge in consumer (energy) prices has led to a notable pullback in consumer sentiment. In December, euro area consumer confidence declined for the third month in a row, though the survey remains above its long-term average and not far below its pre-pandemic level.

Similarly, sentiment in the services sector has eased notably due to surging Covid-19 cases, as signalled by the December PMI reading in the euro area (figure 4). The good news is that services activity has so far deteriorated notably less than during previous waves and has remained in expansionary territory. The manufacturing PMI index also suggests a continued expansion with only a marginal month-on-month change in December. Across economies, the loss of momentum was heavily concentrated in Germany, where a composite PMI index dropped to 49.9, and points to a contraction in output. This is likely due to Germany’s higher exposure to global supply chain disruptions which continue to weigh on activity in the common bloc.

Against this background, we expect the softness in activity seen in Q4 2021 to extend into the first quarter of 2022. After challenging winter months, we nonetheless forecast that growth will re-accelerate to a strong (and above potential) pace, and solid momentum will continue into 2023, assuming that Omicron (and possibly new variants) represent only a short-term drag on activity and supply chain disruptions will gradually ease. In year-on-year terms, real GDP growth in the euro area is expected to moderate to 3.5% in 2022 and 2.4% in 2023, after 5.1% last year.

US: strength in activity

The recent activity data in the US suggest that the economy re-accelerated to a solid pace heading into the new year. Although November retail sales growth moderated to 0.3% mom, it follows an upwardly revised increase of 1.8% mom in October, and likely reflects a strong pull-forward effect with earlier-than-normal holiday shopping. Similarly, after a strong 1.7% mom pick-up seen in October (largely reflecting hurricane-related payback effects), industrial production increased by a more moderate yet still respectable 0.5% mom in November, likely supported by some easing of supply chain disruptions.

The outbreak of the Omicron variant is a downside risks for the US economy, but we believe it will not overwhelm the healthcare systems and prompt a tightening of mobility restrictions. Coupled with increased adaptability to new variants, we maintain the view that the US economy is well positioned for sustained momentum in activity over the winter months. Along with a pullback in consumer sentiment, the main drag on activity from Omicron will, in our view, stem from increased absenteeism due to a rapidly rising number of workers (and their close contacts) that are forced to isolate.

The services sector will bear the major burden of the Omicron wave, as already signalled by PMI readings in December (figure 5). Similarly to the manufacturing sector, activity in services softened last month, with the headline ISM index for services down from an all-time high of 69.1 to 62.0. Although the December drop exceeded market expectations, and signals moderating near-term expansion, the overall level of services activity remains elevated from a historical standpoint.

Our analysis suggests a relatively limited drag from cooling services sector activity on real GDP growth in the first quarter of 2022. Against this backdrop, we assume that solid momentum from end-2021 will largely carry over into this year, and that sequentially lower growth rates will mostly reflect a normalisation in the growth pattern towards a more sustainable pace as pandemic-related catch-up effects dissipate. All in all, we expect the US economy to expand by 3.6% in 2022 and 2.3% in 2023, from 5.6% last year.

China: a balancing act

The year 2022 will once again be a balancing act for Chinese policymakers straddling the objectives of prioritising growth and addressing risks in the economy. While the government is expected to set an annual growth target around 5.5%, even reaching that level will be difficult, with most estimates for 2022 currently set around or only slightly above 5.0%.

Looking back, GDP growth slowed notably over 2021 to levels that are generally below the pre-Covid trend – from 18.3% yoy in Q1 (driven by 2020 covid base effects) to 4.9% yoy in Q3. However, available indicators for the fourth quarter suggest that activity did recover at the end of the year after a slump in Q3. Such indicators include an improvement in manufacturing sentiment (NBS: 50.3 and Caixin: 50.9 for December), industrial production (from 0.05% mom in September to 0.4% mom in both October and November) and credit growth (from 9.9% yoy in September to 10% in October and 10.1% in November after several months of deceleration). Still, growth likely slowed further in year-over-year terms in Q4, leaving our expectation for 2021 GDP growth at 8.2%.

The main economic challenge for China in 2022 will be supporting growth without relying on a strong expansion in construction activity as the sector continues to deal with the fallout from highly indebted developers running into liquidity troubles. Though Evergrande, which defaulted in December and is currently going through a restructuring, is the most prominent of such cases, many other developers are also facing a cash crunch.

Covid developments also present an important uncertainty for the economic outlook in China given the government’s strict ‘zero-covid’ policy, which has led to stringent lockdowns of various ports and cities at different times over 2021, including the ongoing lockdown of Xi’an. Together with the global spread of the more transmissible Omicron variant, this policy approach, if maintained, risks leading to important economic disruptions in the beginning of 2022.

Given these headwinds, it is not surprising that Chinese policymakers have recently communicated a policy shift toward supporting and stabilising growth, particularly through moderately easier monetary and fiscal policy. On the monetary side, this has included a 50 basis point cut to the Reserve Requirement Ratio (to 10% for large banks) in mid-December and a 5 basis point cut to the 1-year Loan Prime Rate (LPR) at the end of December. Some further monetary policy easing (whether through RRR cuts, LPR cuts or a combination of the two) is on the table for early 2022, though it will likely remain moderate. Meanwhile, fiscal policy is also being used to help stabilise growth, particularly through local government bond issuance and tax cuts. Together, these measures should help year-over-year growth figures recover toward 5%, leading to 2022 annual growth of 5.1%.

Inflation: a gradual normalisation

Inflationary pressures accelerated sharply towards the end of 2021, with inflation readings at multi-decade highs in the US and the euro area (figure 6). A number of pandemic-related factors continue to push inflation higher: first, a strong recovery in energy prices, including crude oil and natural gas. Second, the reopening of economies, in particular, the sectors severely hit by lockdowns where prices are normalising from depressed levels. Third, persistent global supply chain disruptions have led to a surge in pipeline price pressures and robust core goods inflation.

We maintain the view that most of these inflation drivers are unlikely to create lasting price pressures. As we move through 2022, inflation should, therefore, gradually moderate from currently elevated levels. Central to this forecast is our expectation of a stabilisation in energy prices, implying more favourable base effects. In addition, goods inflation is expected to decelerate, assuming some alleviation in global supply bottlenecks and a normalisation in consumption patterns (i.e., a rotation towards services).

Admittedly, our inflation outlook is subject to considerable uncertainty and near-term upside risks. As global supply chains remain vulnerable to pandemic-related restrictions, in particular those in Asia, the spread of Omicron could lead to stronger and longer-lasting price pressures in core goods items than currently envisaged. Similarly, should natural gas (and electricity) prices in Europe re-accelerate, or remain elevated beyond winter months, energy price inflation would likely become notably stickier.

In the euro area, headline HICP inflation accelerated to 5.0% yoy in December, moderately above consensus expectations, while core inflation remained stable at 2.6% yoy. In our view, the December print marked the peak in euro area headline inflation, and a pronounced disinflationary path should start in early 2022, as technical factors (including the German VAT base effects) and the boost from energy price inflation gradually unwind. However, the latter is the largest uncertainty of our outlook, in particular with respect to the pace and extent of the passthrough of earlier natural gas price increases that could partly offset the disinflationary effect from a stabilisation in oil prices.

Taking on board the lagged passthrough of higher natural gas (and electricity) prices, and the evidence of still building pipeline pressures from supply bottlenecks, we have raised our forecast for euro area inflation from 2.3% to 2.7% in 2022, after 2.6% last year. However, this annual average forecast for 2022 masks a pronounced disinflationary path that is present in our monthly estimates. In 2023, we expect headline inflation to average 1.9%, broadly in line with the ECB’s inflation target.

In the US, CPI inflation rose to 7.0% yoy in December, in line with market expectations, while month-on-month inflation came in at 0.5%, slightly down from 0.8% in November. Housing (and related items) was by far the largest contributor to headline inflation last month, while energy prices contributed negatively for the first time in a long time. As a result, core inflation rose to 5.5% yoy, which implies that core PCE – a preferred price index of the Fed – picked up by 4.8% yoy in December.

We have increased our 2022 inflation forecast from 3.0% to 3.9%, reflecting still strong (and broadening) price pressures. We believe that housing costs will continue to drive inflation up in the first quarter of 2022, while Omicron-related labour shortages might keep upward pressure on some other items in the core CPI consumer basket. Headline inflation is expected to return back to the Fed’s 2% target by the final quarter of 2022 amid more favourable base effects kicking in and some easing in global supply chain disruptions.

Central banks: Fed’s hawkish pivot

At the final policy meeting of 2021, the Fed signalled a hawkish pivot towards a faster monetary policy normalisation. In view of rising risks of more sustained inflation and rapid progress in the labour market recovery, the FOMC decided to accelerate tapering by doubling the pace to USD 30 billion per month in January, while hinting at pulling forward rate hikes. We now expect the asset purchases programme to end in March, opening the door for the first 25 bps rate hike already in the same month. Altogether, we pencil in four 25 bps rate hikes for 2022 (vs. three hikes projected in the December FOMC dot plot), followed by another three 25 bps hikes in 2023. In addition, the balance sheet normalisation is also on the table, as the December FOMC minutes stated that Fed could begin shrinking its USD 8.8 trillion balance sheet “relatively soon after beginning to raise the federal funds rate”.

In Europe, the ECB has also taken another (small) step towards normalising its monetary policy. As expected, the central bank announced the end of net purchases under the Pandemic Emergency Purchase Programme in March 2022, though proceeds from maturing bonds will be reinvested ‘flexibly’ at least through 2024, a year longer than previously envisaged. In order to smooth the exit from the extraordinary monetary setting, the ECB will raise the amount of bonds bought under its regular Asset Purchase Programme (APP). As a result, APP purchases will double to EUR 40 billion before gradually returning to the original EUR 20 billion in Q4 2022.

Against this backdrop, the updated staff projections for headline inflation showed a sizable upward revision for 2022 to 3.2% (vs. 1.7% in September). However, inflation is projected to fall back below the target in 2023, though only moderately at 1.8% and with upside risks. As the first interest rate hike remains conditional on ending the remaining bond purchases and inflation reaching 2% in the coming one to two years and staying there, lift-off appears unlikely this year. Our baseline forecast assumes one 25 bps hike in the refinancing rate in 2023, in addition to raising the deposit rate from negative territory.