After two years of the pandemic, the U.S. economy now faces several challenges which keep central bankers awake at night. Supply chain interruptions caused by China's covid breakout, Ukraine crisis, labor shortages, and 40-year high inflation are affecting growth expectations and market morale in global markets. Having said that, Gross Domestic Product (GDP), which is the total value of goods and services provided by the economy, fell 1.4% on an annualized basis in the first three months of 2022, a considerable dip from the 6.9% increase recorded in the fourth quarter of 2021 amid the recovery of the pandemic. This is the first downturn since the spring of 2020 when a pandemic-related shutdown slowed economic development. The contraction stemmed from a widening trade deficit, a slower pace of inventory investment by businesses compared to the previous year, and the fading government stimulus associated with the pandemic. Moving forward, the unexpected downturn and increasing inflation pose a problem for U.S. President Joe Biden and Democrats as they prepare for the November midterm elections. Furthermore, the data adds to concerns that rising inflation and the potential of Federal Reserve rate hikes will trigger an economic deacceleration. Many economists believe that the dismal economic data for Q1 will unlikely alter Fed's plan and the economy can tolerate rising interest rates and return to modest growth in the second quarter and beyond, owing in part to strong consumer and corporate spending resiliency. The major question would be how the Fed can strike the correct balance between reducing price pressures and sustaining economic growth.
Consumer and business spending remains resilient while the trade deficit widens. Consumer expenditure, the primary driver of the U.S. economy, increased in the first three months of the year. Personal consumption expenditures climbed at a seasonally adjusted annual rate of 2.7% in the fourth quarter of last year, compared to 2.5% in the fourth quarter of the previous year. Companies are also investing in factories, equipment, and software, all of which will increase productivity in the medium and long term. Business investment increased at a 9.2% annual rate in the first quarter, up from 2.9% in the fourth quarter of 2021. However, Because of the shortage of workers market conditions shifted as employers cling to employees, business hiring ramped up, and wages improved, eventually leading to high consumer spending. Nevertheless, many of the positives were negated by one-off factors. Most notably, imports increased dramatically during the first quarter as U.S. supply failed to keep up with rising demand. Exports declined 5.9% while imports increased 17.7%, resulting in a 3.2% point negative on headline GDP from net exports. In addition, a 0.8% reduction (annually) in company inventories impacted the total output.
High inflation weighs on consumer spending power, while Fed is ready with a 50 bps hammer on the table. Despite the fact that average hourly earnings increased by 5.6% throughout the same time period. Inflationary pressures are eroding many workers' pay raises, and rising costs are posing problems for many firms. Having said that, the consumer price index increased 8.5% year on year in March, a four-decade high. Furthermore, the Fed's preferred price gauge, the Personal Consumption Expenditure Index, climbed to 7% in Q1 2022 from 6.4% in the previous quarter, indicating further price pressure. The covid in China and the war in Ukraine have added to the pricing pressure, making everything more expensive, from bread to cheese, oil, and commodities. Accelerating labor costs in the United States and a strong consumer is effectively giving the Federal Reserve the go-ahead to raise interest rates by a half-point next week to tamp down pricing pressures.
Strong labor market conditions, resiliency in the service sector, but weak manufacturing growth. The job market in the United States remains tight, with the unemployment rate remaining at 3.6% in March, down from 3.8% in February. In addition, the labor force participation rate has increased to 62.4%, exceeding expectations of 62.2%. The only miss was in nonfarm payrolls, which were 431k instead of the projected 490K. Furthermore, the service sector remains resilient, with the ISM service PMI reading 58.3 vs 56.5 previously. The manufacturing sector remains slow, with an ISM manufacturing PMI of 57.1 below expectations of 59. While the U.S. and its allies push sanctions on Russia, geopolitical tensions remain on the desk. According to the most recent geopolitical news, Germany is facing gas supply problems. EU leaders are deliberating on measures that will allow them to pay Russia in a sanctioned compliant manner. A sudden ban on Russian crude, on the other hand, would produce a recession, given the EU member states' heavy reliance on Russian energy products.
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