U.S. Economic & Credit Outlook
The U.S. economy produced mixed results in the first half of 2022, with strong nominal growth eroded by the highest inflation in decades. Gross domestic product adjusted for inflation (“real GDP”) fell 1.6% in the first quarter as a wider trade deficit and a slower pace of inventory accumulation more than offset a 2.0% rise in domestic final sales. While the advance estimate of second quarter GDP will not be available until late July, economists in the latest Federal Reserve Bank of Philadelphia’s Livingston Survey forecast real GDP growth of 0.5% in the first half of 2022, which would imply a 2.6% gain in Q2. Before adjusting for inflation, nominal GDP was much higher: 6.6% in Q1 and an estimated 8.1% in Q2. For the second half of 2022, these economists expect real GDP to expand by 2.1%.
Employment has grown rapidly so far in 2022, pushing the unemployment rate down to 3.6% in May from 3.9% in December 2021. Demand for workers remains strong, with 1.9 job openings for each unemployed person as of April. Although hiring is likely to slow from this very rapid pace, we expect it to remain solid in the second half. Higher hourly pay and rising employment drove solid gains in wage and salary income so far in 2022, although overall personal income failed to keep pace with inflation as transfer payments slowed sharply. Real personal consumption expenditures (PCE) slowed to 1.8% in Q1 from 2.5% a quarter earlier, as consumers dipped into savings and increased borrowing. Recent increases in gasoline and food prices probably forced households to devote a larger share of income to those items, and real consumer spending growth is likely to be similarly slow in Q2.
Home sales fell as soaring prices and mortgage rates cooled demand, while high inflation turned strong nominal residential investment into only a 0.4% real gain in Q1; it probably turned negative in Q2. Industrial output rose 7.0% in Q1, with even faster gains in April and May. Rapidly rising output pushed capacity utilization up to 79% in May, its highest level since 2018. Real business investment rose 10.0% in Q1, and economists expect a gain of 7.3% in Q2. While order growth has remained sturdy, business confidence has slipped in response to tighter monetary policy (discussed below). We expect slower growth in both industrial output and business investment in the second half.
Strong demand and, until quite recently, accommodative monetary policy drove inflation sharply higher in 2022. Compared to the same month a year earlier, the consumer price index (CPI) reached a high of 8.6% in May, and the PCE deflator peaked at 6.6% in March. Inflation broadened beyond food and energy prices, and the core CPI (excluding food and energy) rose to a peak of 6.5% YoY in March, while the core PCE deflator reached a high of 5.3% YoY in February. Although those levels probably mark the peak in core inflation for this cycle, we do not expect to see major progress on inflation until the fourth quarter.
High inflation prompted a sharp turn in monetary policy. The Fed hiked the fed funds rate by 150 basis points to a target range of 1.50%-1.75%, and, unlike the Fed’s mid-June projections, markets as of June 30 were pricing in a fed funds rate of 3.4% by year-end, a peak at 3.5% in mid-2023, and a decline to 2.9% at year-end 2023. The Fed also ended quantitative easing in March and, in June, began to reduce its securities holdings by up to $30 billion Treasuries and $17.5 billion of mortgage-backed securities per month. The Fed plans to double its monthly portfolio runoff starting in September. These actions combined to drive up benchmark interest rates and the U.S. dollar, widen credit spreads, and push down common equity prices — sharply tightening financial conditions.
To bring inflation down, the Fed must tighten financial conditions and slow money growth to levels that reduce aggregate demand and bring it into (noninflationary) balance with supply. Because monetary policy acts with a lag and has limited impact on the economy’s supply side, it will be very difficult, although not impossible, for the Fed to reduce inflation from current levels back toward its 2% long-term target without overshooting. We expect the economy to continue its expansion this year, although recession risk will increase in 2023.
Despite a challenging economic backdrop, fundamental credit quality remains healthy. The ratio of debt to GDP has continued to decline across most sectors of the economy. Household and financial business balance sheets look especially strong. Business bankruptcy filings, household and business debt service, and bank loan delinquencies and charge-offs all remain historically low. Financial companies, which are the largest issuers in the preferred market, should