Headwinds outside of the United States pose a challenge to growth and policymakers

It’s been a while since anyone entertained thoughts of a return to the roaring twenties. Instead, many are harking back to the seventies—a period of runaway inflation and weak growth. In a remarkable about-turn, talk of stagflation, even recession, has grabbed the headlines, as the US economy shrank 1.4% in the first quarter of 2022.¹ In the Euro Area as well, the trajectory of the recovery flattened with growth of 1.08%.² Multiple factors are at play. Russia’s invasion of Ukraine sent shockwaves through distressed global supply chains and has led to both economies shrinking rapidly. China’s persistence with a stringent zero–COVID-19 policy has slowed growth and restricted global supply. And finally, emerging markets appear vulnerable to the rising value of the dollar, higher prices at home, and tightening monetary policy abroad. It is not surprising that the International Monetary Fund revised its April global growth forecast for 2022 down to 3.6% from 4.9% in October 2021.³

While the global economic recovery slows, the US consumer has held steady—up until now. Broader and more persistent-than-anticipated inflation has dragged consumer confidence down and threatens to slow consumer demand as it shifts away from a lopsided pandemic-induced pattern of goods over services.⁴ The Federal Reserve (the Fed) has responded by pivoting to a more aggressive removal of accommodation. However, the headwinds from outside the United States are expected to be an obstacle to growth and could potentially make the Fed’s policy-pivot more challenging than it already is.

Growth in Q1 in the United States was dragged down by net exports

Consumer spending, residential investment, and business investment added to growth during the first quarter. This paints a picture of healthy domestic demand. Businesses continued to restock inventory at a relatively rapid rate, though not as fast as in the previous quarter, therefore subtracting from growth. Government spending and investment also slowed as fiscal support continued to wane. However, the real damage to growth was done by net exports, which subtracted 3.2 percentage points from overall growth over the quarter. Exports fell by 5.9%, while imports increased by 17.7% during the quarter.⁵ A closer look reveals a few insights.⁶

US demand for imported goods is above trend and growing

• US demand for consumer goods continues to be relatively strong but lopsided. Imports of consumer goods are far above trend and have continued to increase. This pattern has been driven by very strong demand for durable goods. Real imports of durable consumer goods in Q1 2022 were 50% higher than in Q1 2019; real imports of nondurable consumer goods were 25% higher.
• US business investment demand is skewed toward technology equipment. Imports of capital goods are above trend, even though imports of civilian aircraft and engines have been depressed. This is because imports of computers, peripherals, and parts have increased rapidly as the degree of virtual work and automation increases. Other capital goods imports are also above trend, signaling that business investment is healthy.
• Real imports of sea transport freight services for incoming goods have exploded since the beginning of 2020, despite a sharp increase in prices. This represents very strong demand for imported goods.

External demand for US goods and services is not as spectacular

• Real exports of goods have flattened. Exports of consumer goods to the rest of the world are above trend because of strong demand for nondurable goods. However, exports of consumer goods fell sharply in Q1 as demand cooled. Exports of capital goods as well as vehicles slowed in Q1 and remain below trend.
• Real exports of services, which represent 30% of all US exports, remain far below trend, particularly because of significantly less travel to the United States.

Supply chain stress is probably becoming worse

• Exports and imports of industrial supplies and materials fell, while prices soared in Q1, indicating a likely intensification of global supply chain stress.

China’s zero–COVID-19 policy could harm US growth and the fight against inflation

China plays a pivotal role in global supply chains. It is home to almost 30% of global manufacturing as well as six of the 10 busiest ports in the world.⁷ However, wide-scale lockdowns have slowed production in China. This is evidenced by the country’s plummeting purchasing managers’ index for manufacturing in March and April.⁸ Additionally, Chinese ports are becoming more congested. At the time of writing, ships waiting to be loaded at the Port of Shanghai have increased 34% since April.⁹

If China persists with a zero–COVID-19 policy, and the wide-scale lockdowns that come with it, then supply chain–induced inflationary pressure is likely to increase around the world, including in the United States, where demand for imported consumer goods and electronics is particularly strong. Higher prices are expected to erode purchasing power, leading to slower consumer spending, slower growth, and potentially higher inflation expectations. The same chain of developments in US export markets will likely reduce demand, therefore subtracting further from US growth.

Russia’s invasion of Ukraine adds to economic concerns

Russia’s invasion of Ukraine has resulted in a severe humanitarian crisis. It has also become a source of global inflationary pressures. The European Union’s proposed phased embargo on Russian oil could lead to further increases in energy prices. Russia sells 60% of its oil to countries in the West and faces restrictions in its ability to pivot to the East.¹⁰ Proposed sanctions that curtail shipping insurance for vessels carrying Russian oil could make the pivot even more difficult. At the moment, it is unclear if other oil producers will choose to increase production. Even if they were to increase production, it is uncertain whether such an increase could cover the potential loss in global oil supply from Russia. Apart from energy, the conflict in Ukraine has also disrupted the supply of food, fertilizers, and other raw materials.

Higher energy and food prices due to the conflict could lead to protectionism, which aggravates the problem. Indonesia’s ban on the export of palm oil and India’s ban on the export of wheat are prime examples.¹¹ An increase in inflationary pressures will have implications for countries across the globe, including the United States. Europe is likely to face the brunt due to its hitherto strong dependence on Russian energy. An overall dampening of demand from Europe and other trading partners might weigh on growth in the United States.

The Fed’s in a tight spot

The composition of demand from the United States, China’s zero–COVID-19 policy, and a protracted war in Ukraine could combine to increase inflationary pressures and put the brakes on growth. While the Fed must tighten to moderate consumer demand and anchor inflation expectations, it has no control over external factors that choke supply chains. If inflation and inflation expectations were to rise because of supply-side chaos, the US economy could experience persistently high prices, higher interest rates, and a further dip in growth. The Fed is caught between a rock and a hard place, and middle ground is vanishing at an astonishing rate. While stagflation or recession is not yet the base case for the United States, the likelihood of these outcomes has increased.

For a more in-depth analysis of the headwinds facing the US economy, read our US Economic Forecast, Q2 2022, publishing mid-June.