One of the key mantras about monetary policy is that it works with lags. Sometimes the lags are short, particularly if rate changes are amplified by sudden shocks, such as an oil spike, a financial crisis, geopolitical turmoil, or other surprising event that upends public expectations. This time, the lag has been considerably longer, despite the energy shock from the war in Ukraine. The surge in oil prices in recent months has not had the usual punishing effect on activity primarily because of the ample financial resources – i.e., the aforementioned savings and hefty profits – that enabled households and businesses to absorb the increase and sustain spending. A strong job market and rising paychecks also cushioned the blow from higher energy costs.
These bulwarks are becoming less potent, however, and their ability to absorb oil-price spikes and other gathering headwinds suggest that the economy will hit a rough patch in the final months of the year. Importantly, unlike the brief oil price spike last year that the administration was able to reverse by drawing on its petroleum reserves to offset supply cuts, energy prices should stay high for the foreseeable future. For one, the world’s primary producers, Saudi Arabia, and Russia, are extending production cuts for the rest of the year. For another, Washington has not rebuilt its oil reserves which could be used to offset that reduced supply as was the case last year.
That said, while rising oil prices are never going to be welcomed by households and businesses, the recent pickup has not been particularly large compared to the gyrations of the past few years. In fact, oil prices are broadly in line with where they were a year ago. By comparison, the runup over the first half of last year left oil prices on average 60% higher than a year-earlier, so it would have taken a much bigger toll on activity had it not been quickly reversed over the second half. However, if the ongoing supply squeeze pushes oil prices still higher, say over $100 a barrel from the current $90, on a sustained basis, the impact on the economy would surely increase. Not only would it constitute a tax increase for millions of motorists, but by driving up inflation it would also prod the Federal Reserve to maintain interest rates higher than otherwise.
More Hurdles Ahead
The drag from high oil prices is not the only headwind the economy faces in coming months. The pause on student loan repayments granted during the pandemic has expired, and tens of millions of borrowers must now begin meeting their obligations, something that will crimp many budgets and force spending cutbacks. Another pandemic era source of support has also expired, namely government payments to childcare providers that lowered costs for millions of parents and helped them to return to the workforce. The removal is a double whammy for the economy, as it puts a dent in the labor force that is already short of workers and a dent in the wallets of parents facing higher childcare costs, most of whom are low-income households who have little savings to tide them over.
By themselves, these impediments – high oil prices, student loan repayments and more expensive childcare – are not enough to bring down the economy. Add two more shocks, however, and the drags on activity add up. One is the autoworker strike that, as of this writing, is poised to spread beyond the three auto plants initially struck and is already sending tremors through the auto industry, which is struggling to rebuild inventory on dealer lots. The crimp to production from the strike will exacerbate the shortage of vehicles and lead to higher prices, which, along with the surge in rates on auto loans, is already crimping demand.
Finally, as the calendar turns to October, the prospect of a government shutdown looms large. A short shutdown would not have much of an impact, but anything longer than a few weeks – which, given the rhetoric surrounding the issue, is certainly a possibility – would make a noticeable dent in activity during the fourth quarter. Beyond the direct effects of lost or delayed paychecks for millions of workers who are either furloughed or
laid off in the private sector because of the shutdown, the indirect effects on the financial markets, including a possible wealth-destroying slump in stock prices, would likely result.
Heightened Recession Risk
In its last policy meeting on September 19-20, the Fed upgraded its growth outlook for both this year and next, underpinning the expectations of most officials that another rate hike is likely this year and fewer rate cuts were likely next year than thought three months ago. This more hawkish sentiment is understandable given the resilience the economy has shown so far to previous rate hikes and an inflation rate that, while receding, remains well above the Fed’s 2% target. However, policy makers may be underestimating the near-term shocks buffeting the economy, which could well short-circuit the economy’s momentum heading into 2024.
While the shocks alone should not cause a recession, they are unfolding just as the lags from the rate-hiking campaign are kicking in. True, households and businesses that have locked in low rates have insulated themselves from the increases over the past 18 months. But that still leaves a broad swath of consumers who need to borrow to purchase a home, car or rely on credit cards for other purchases. With mortgage rates topping 7% for the first time in more than 20 years and rates on auto loans and credit cards soaring to record highs, this group of borrowers will be pulling in their horns. Meanwhile, small businesses that need to refinance expiring low-rate loans are not only facing much higher rates but are increasingly being turned away by lenders that are tightening credit standards. At this point the Fed is more worried about sticky inflation than a recession, as it believes the former poses more of a long-run threat to the economy. It may well be right; but keeping rates higher for longer in deference to that tradeoff also increases the odds of a recession over the near term.