We never know when a recession starts until the National Bureau of Economic Research, the unofficial timer of business cycles, tells us, and that can be months after it is over. But the economy is obviously cruising above water now despite 17 months of Fed rate hikes. One reason may simply be that the full impact of higher rates hasn’t yet been felt. True 17 months feels like a long time; but historically, it has taken an average of nearly two years between the central bank’s first rate hike and a recession. If that historical pattern holds, we can expect the downturn to set in early next year, which incidentally, is the timetable we expect to evolve.
That’s not to say that the economy has been unscathed from the surge in rates. While consumers overall are still flexing their spending muscles, they are paying considerably more to finance their purchases. Interest rates on credit cards are at record levels – as is credit card debt – and delinquencies are rising, on both credit cards and auto loans. Lenders are responding by raising borrowing standards, pointing to reduced credit availability in coming months. Would-be home buyers are facing even greater hurdles. Mortgage rates recently leaped over 7% for the first time in more than 20 years, lifting housing affordability out of reach for a growing swath of households.
Indeed, even those who can still afford to buy a home are finding that there is scant supply to choose from, thanks to high mortgage rates. That’s primarily because homeowners are staying put, not putting their property on the market and giving up the low 3-4% mortgage rate obtained when they either refinanced or purchased their home during the low-rate environment prior to the Fed’s tightening campaign. Ironically, this is boosting construction activity, as builders are filling a void in the resale market for existing homes. But to sell those homes, builders are offering rate concessions to buyers, which is not a sustainable model as they too have to borrow funds at ever higher rates.
Depleting Savings
As already noted, the broader economy has weathered the rate hikes so far and there is no sign it is about to fall off a cliff anytime soon. But its main growth driver is about to run on fewer cylinders, pointing to slower growth over the remainder of the year. Most notably, consumers are poised to lose a major source of spending power, as the huge pool of excess savings accumulated since the onset of the pandemic is running dry. Estimates vary as to how much households have padded their bank accounts with the trillions of dollars doled out by the government through its stimulus payments and the funds that were unspent during lockdowns. But a recent study by the San Francisco Federal Reserve bank provides some idea of the magnitudes involved. The researchers calculated that households accumulated $2.1 trillion in excess savings from early 2020 to August 2021, that is savings over and above what they would have saved during normal times. Since August 2021, they have dipped into that pool deeply to support spending, averaging about $100 billion a month. After all those drawdowns, it is estimated that only $190 billion of excess savings is left, which the authors estimate will be fully spent by the third quarter of this year.
Removing $100 billion a month in spending is not a trivial headwind, considering that it virtually equals the $108 billion average monthly increase in personal consumption from January to June of this year. It means that consumer spending will be more reliant on income growth and/or borrowing. Still, to the extent that these savings have driven spending, that engine is poised to cool down considerably in the final months of the year. Keep in mind too that the scheduled restarting of student loan repayments after September will also deter some spending, particularly among millennials. Simply put if the economy is indeed running on fumes, they are poised to dissipate soon. The question is, is there enough firepower to keep the growth engine humming, even if in a lower gear?
Tailwinds
That, of course, is where the rubber meets the road for the Federal Reserve. Even if the central bank decides it is finished with hiking rates, as many anticipate, the financial markets are not. Investors are ever-more convinced that the economy has considerable momentum left and have driven up long-term rates sharply over the past month. As of the third week in August, the bellwether 10-year Treasury yield – which strongly influences mortgage and other critical rates in the U.S. – soared to the highest level in about 15-years. Among other things, that indicates investors believe the era of cheap money which prevailed from the 2008 financial crisis to the pandemic is over. The mantra that rates will “remain higher for longer” is firmly embedded in the mind-set of the financial community.
Even if a recession sets in investors do not believe that interest rates will return to the near-zero level that prevailed over most of the last decade. For one, any recession is expected to be mild and inflation to remain stubbornly above the Fed’s 2% target. While shorter- term rates, which the Fed has more control over, have barely budged over the past month, neither have they declined from their elevated levels, reflecting investor expectations that the Fed will not be cutting rates anytime soon. Hence, in addition to the headwinds from reduced savings and student loan repayments, the economy will need to overcome the hurdle of sustained high interest rates to stay afloat.
The question is, can it? The good news is that there are some powerful tailwinds that will counteract the gathering headwinds. One key buffer is the still-strong job market, featuring an unemployment rate near historic lows and sturdy wage gains. Importantly, those gains are occurring alongside easing inflation, a combination that is boosting real incomes. Adding to the crosscurrents buffeting the economy, high interest rates are providing savers with the most generous returns in more than 15 years. No doubt, interest rates inflict more pain than gain when they rise as sharply as they have. But the income boost from higher interest payments accruing to a rapidly aging population should cushion the blow by injecting more purchasing power into retirement accounts. These buffers may not be enough to prevent a recession, but they should limit its severity and, importantly, soften the impact on unemployment.