Philipp Carlsson-Szlezak, Paul Swartz, and Martin Reeves
Oct. 19, 2021
As business leaders enter the fall, a confluence of negatives is clouding their outlook on the economy. The big bounce back from last year’s trough has lost steam, stimulus is fading, and a plethora of softer economic data is weighing on sentiment. All of this unfolds against the backdrop of the pernicious Delta variant, reinforcing a downbeat narrative.
Yet, the economic outlook in the next year remains attractive once we examine what’s driving the current slowdown. To understand why, we need to look at the nature of the rebound, the risks and opportunities as the expansion is handed off to consumers, and the potential ways the current cycle could end.
What’s Really Driving the Current Slowdown
Policy makers and vaccine developers delivered an enormous growth bounce globally — particularly in the U.S. where a massive V-shaped recovery has been achieved.
But deceleration is built into any V-shaped recovery: Outsized growth rates pull activity out of the trough but such growth cannot persist as year-on-year comparisons are progressively made against stronger base periods.
With a few exceptions, we expect global growth to peak this year, followed by a deceleration next year.
The economy is running into additional negative surprises, which are driving uncertainty and fear: Consumer confidence has dipped markedly in recent weeks, while firms’ outlook has dimmed too, as seen in falling PMIs. Inflation, though moderating recently, has not yet fallen back to comfortable levels, while firms are facing bottlenecks in labor and product markets. This is all occurring against the backdrop of the Delta variant, which brings the prospect of waning of vaccine effectiveness, more breakthrough infections, booster shots, and potentially new rounds of restrictions.
Adding complexity, all of this is unfolding in that critical stage of the recovery when the crutches of policy support fade and the private sector — consumers most of all — have to drive the expansion forward. That hand-off is part and parcel of any recovery, but given the unusual size of stimulus and its withdrawal, the slowdown now happens in a high-risk window.
If the hand-off to consumers is successful, we project year-over-year growth will slow from as high as 7% in 2021 to perhaps 2.9% in 2022. What looks like a brutal deceleration, however, is in fact necessary. (The economy should not overheat too much.) Plus the projected 2.9% would leave the U.S. economy still operating comfortably above its trend growth of around 2%, below which an expansion becomes sharply more vulnerable.
Five Reasons Consumers Can Pick Up the Economic Expansion
It’s understandable that the slowdown, unexpected headwinds, and tricky hand-off to consumers should encourage negative expectations. But the headwinds that consumers face now should be netted against the tailwinds and the sources of strength that households have built. Here are five prominent concerns and why they are overblown.
First, while economic prospects are still widely equated with the Delta variant’s path, the reality is that the economy largely decoupled from the virus early on. That was not only a function of strong stimulus but also of adaptability. Households and firms have learned to live with the virus and that learning is unlikely to be undone by the Delta variant. For example, even when cases and hospitalizations were at their highest in Florida, we did not see a sharp retreat in economic activity.
Second, while fiscal stimulus to households is rapidly fading, the labor market is booming. Remarkably, despite historic unemployment numbers, the stimulus helped personal incomes soar in 2020 and early 2021. Now, with a record number of job openings and many firms struggling to fill them, households are in a good position to replace fading stimulus with employment and higher wages, ensuring that consumer spending power will remain strong.
Third, while current inflation is eroding wage gains it is unlikely to last. U.S. price growth continues to look transitory – driven by the idiosyncrasies of a torrid reopening and supply bottlenecks – whereas a tight labor market will not easily return to slack conditions. The prospects for a tight cycle delivering both wage and productivity gains remain strong.
Fourth, much has been made of soaring house prices undercutting confidence and household budgets. However, home prices are not the same as housing cost. After factoring in record low financing conditions, the index of housing affordability is broadly in line with pre-pandemic levels and significantly more favorable than in the decades before the global financial crisis.
Finally, there is fear of a fickle household sector pulling back at any moment, and the continued high savings rate provides some cover for this idea. But that view ignores the large, accumulated savings, particularly relative to levels of household wealth, which is already high. This suggests that households have room to spend and carry an already strong expansion further.
How Cycles End
Taken together, consumers are in a strong position to pick up the expansion. The Delta variant may shift the timeline somewhat, as growth expectations have declined for the third quarter but risen for the fourth. But it is less persuasive that Delta changes the overall shape of the recovery or the level at which growth will stabilize.
Yet all things must end eventually, and indeed the post-Covid cycle will reach a 2019-like maturity much faster than any cycle before it, as labor markets tighten and growth decelerates. With this will re-emerge the question of 2019: How long can the cycle last?
Traditionally, risk assessments of the cycle examine exogenous shocks last or not at all, but Covid has reminded everyone of their pertinence. Events like destructive solar flares, great power wars, or systemic cyber-attacks are all possible, but like pandemics, these are low-probability, high-impact events. A baseline awareness of the risk does not inoculate or even assure an advantage, aside from recognizing that even the strongest expansion can be ended by shock.
Next on the list of risks are endogenous imbalances that tend to build slowly but then unravel rapidly. These can play out both in the real economy — think an unsustainable investment boom — or in the financial system, which, upon unwinding, usually poses systemic challenges. Today’s real economy imbalances are not extreme, nor do private-sector balances suggest strained finances, although each have pockets of activity that could grow into problematic imbalances over time and surprises in the financial system can never be completely ruled out.
This leaves policy errors. In our reading, mistakes by those in charge of the economy is the biggest risk to the post-Covid cycle. Monetary policy makers, who adroitly backstopped households, firms, and the financial system during the pandemic, run the risk of acting too soon (tightening policy and killing the cycle), too late (risking the inflation regime and being cornered into cycle-ending tightening), and/or with the wrong intensity (generating unwanted volatility).
The reason policy makers are more likely than usual to commit errors is that their world is upside down today. Normally, policy tightening can occur modestly as an expansion slowly ages, leaving room for gradual adjustments or course corrections.
Today, policy makers are not only having to adjust away from super-sized stimulus, they are also having to do it as the economy slows into very tight conditions, while inflation is above target but may be falling fast. While policy makers have a credible strategy to adjust slowly, they are facing a lot of moving economic pieces. The complexity creates a real risk that they find themselves in the wrong position and need to risk the expansion to right the ship.
How Firms Can Manage the Slowdown
For business leaders digesting the macro landscape there is both a practical and reflective lesson.
As growth slows, economic activity will likely settle on levels exceeding pre-pandemic expectations — and this is where operational focus should be. This can be challenging while strong gyrations play out in labor and product markets, but hiring difficulties as well as price growth are likely to abate in the course of 2022. Knee-jerk tactical reactions to the current situation, such as premature price hikes that risk the loss of market share, are unlikely to pay off.
In fact, a broader lesson that Covid and its aftermath offers is to resist the temptation of chasing see-sawing data flow. Covid has been an endless experience of records: the biggest fall, the largest stimulus, the fastest recovery, strong price growth — and now the potential for the strongest overshoot in a generation.
Trying to follow and adapt to all these gyrations has rarely been a winning strategy since Covid broke. Business leaders must take a broader interpretation of the trajectory, followed by calm execution. Today, that broader reading is of a steep but necessary slowdown, an economy running above potential, with tight labor markets, wage, and productivity growth — all helping to underpin an expansion that has the potential to persist for a long time.
Philipp Carlsson-Szlezak is a partner and managing director in BCG’s New York office and global chief economist of BCG. He can be reached at: Carlsson-Szlezak.Philipp@bcg.com.
Paul Swartz is a director and senior economist in the BCG Henderson Institute, based in BCG’s New York office.
Martin Reeves is the chairman of Boston Consulting Group’s BCG Henderson Institute in San Francisco and a coauthor of The Imagination Machine (Harvard Business Review Press, 2021).
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