Judging by the latest forecasts, the outlook for growth in 2022 is positive and, at some point during the year, inflation should start to decline. Uncertainty remains elevated however so there is a risk that key economic variables evolve differently than anticipated. The biggest ‘known unknown’ concerns the future development of the pandemic. Real GDP growth could surprise to the upside should inflation decline faster than expected. A tightening of financial conditions, more supply disruptions and inflation staying high for longer are the key sources of downside risk to growth.
FOMC members' assessment of real GDP growth uncertaintyJudging by the latest forecasts, the economic outlook for 2022 is positive. Real GDP growth should be strong and inflation, whilst staying elevated in the near term, should decline later on in the year[1]. However, this base scenario comes with a high degree of uncertainty. In the US, the members of the FOMC are nearly unanimous in their assessment that uncertainty about growth is higher than the average for the past twenty years (chart 1).[2] With a high level of uncertainty comes the risk that key economic variables evolve differently than anticipated. According to the FOMC, there is an elevated risk of inflation surprising to the upside and a more limited risk of a downside surprise to growth (chart 2).[3] However, a more granular approach is necessary, considering that uncertainty can have many causes, each with its possible implications in terms of growth and inflation surprises.
Sources of upside/downside riskExhibit 1 presents several sources of uncertainty, their likelihood of occurrence and the impact on activity.[4] The biggest ‘known unknown’ concerns the future development of the Covid-19 pandemic. The exponential spread of the Omicron variant and the challenges this raises in terms of vaccination campaigns and vaccine development, imply it is virtually impossible to assess the likelihood that the situation will be brought under control in 2022 or that it might take even more time. In the former case, uncertainty of households and business would drop, triggering an increase in demand – in particular in sectors such as contact-intensive services, which have suffered from restrictions and precautionary spending behaviour –, an acceleration of growth and a further increase of inflation concerns: bottlenecks might intensify due to the pickup in demand. In the opposite case, pandemic-related uncertainty becomes endemic, with further negative effects in the exposed sectors. It might also cause longer-lasting supply disruptions due to health-related absence of staff in production, transport or distribution.
FOMC members' assessment of growth and inflation risks
Alternative scenarios for euro area real GDPThe latest ECB staff projections shed light on this by presenting two alternative scenarios, a mild one – with a faster resolution of the pandemic in the course of 2022 – and a severe one, with recurrent pandemic waves, a lower proportion of the population being effectively protected and a health crisis that continues until mid-2023. The model-based simulations show strong near-term growth under the mild scenario but a technical recession and disinflationary pressures under the severe scenario (chart 3 and 4).
Another potential surprise is that inflation declines faster than expected, due to the absence of second round effects and/or the rapid easing of supply pressures[5]. This would reduce the need for central banks to tighten and fuel a ‘risk-on’ sentiment. Growth would benefit.
Alternative scenarios for euro area HICP inflationHowever, given the intensity of the price pressures, such a scenario has a rather low likelihood. Inflation is more likely to surprise on the upside. Besides, the list of other downside risks is longer. In addition to endemic uncertainty about the pandemic, supply disruptions might continue, thereby weighing on growth and pushing inflation higher. This last point and the possibility that faster wage growth would cause an increase in sales prices imply that the likelihood of inflation staying elevated for longer is even higher than that of ongoing supply issues. Finally, (the prospect of) several rate hikes in the US might cause a tightening of financial conditions and trigger heightened equity market volatility and a widening of corporate bond spreads, thereby weighing on confidence and growth.
