About the author: Larry Hathaway Co-founder of Jackson Hole Economics and former Chief Economist at UBS, who originally published this commentary.
Markets were buoyed by the prospect of a “soft landing” for the US economy. Stocks and bonds rallied strongly last week. Inflation There were better-than-expected reports of inflation, raising hopes that US inflation could be eliminated without a slowdown.
The surprise for many is not the fall in inflation, but the resilience of the US economy. After all, higher inflation has long been predicted—perhaps prematurely. A drop in oil, food and other commodity prices following last year’s war-related inflation is seen as a slowdown in core inflation in 2023. Broadly speaking, today, compared to last year’s high inflation, it is inevitable that year-over-year inflation will be moderate. A temporary, pandemic-related shortage of computer chips, new cars and other goods has eased, providing an opportunity for higher production and lower prices. And finally, market rents in the first half of 2023 can be expected to be moderated by accommodation inflation, much less the U.S. consumer price index.
US headline consumer inflation will soon drop below 3%. It is entirely possible that core measures of inflation will fall within striking distance of the Fed’s 2% target by this time next year.
But while most economists agree that inflation will eventually moderate, few think it can be done without a recession. Strong federal rate hikes, fading fiscal spending tied to the pandemic, and aggressive growth in Europe, Japan and China were seen by many as insurmountable headwinds for the U.S. economy. Bond markets were sending the most powerful signal of all—a deeply inverted yield curve, which is typically the one-best sign of an impending recession.
But the latest economic figures belie US recession fears. The labor market continues to create new jobs. Even at a moderate pace recently, job growth has been twice as fast as labor supply growth. Consumer spending, particularly on services, is proving resilient. Even earlier weaknesses, such as housing, have shown new strengths.
Of course, the problem areas are also visible. After all, commercial real estate is in the doldrums, a victim of high borrowing costs and many workers returning to the office slowly. Business investment spending is also weaker than aggregate final demand. Net exports are a drag on US economic activity.
Still, the main story is one of resilience, especially in the face of the largest Federal Reserve interest rate hike in a generation (accompanied by similar moves in emerging and other developed economies).
Some of the reasons we’ve written about before help explain the economy’s reluctance to roll over, including stagnant consumer spending that has accumulated through household savings during the lockdown, partial replacement of the Covid fiscal stimulus with other government spending (such as the Deflation Act’s subsidies for renewable energy), and the surprising eurozone economy of Russia in Ukraine. The resistance she invaded.
But another reason may be at work for the lack of comment in many reports on the US economy. In particular, because of changes in household and corporate credit since the 2008 global financial crisis, U.S. private sector spending may be lower interest-rate than commonly believed. If so, the Fed’s rate hikes may not be reducing as much demand from the economy as has been seen in the past.
Since the global financial crisis, American households and lenders have undergone a dramatic shift in their attitudes toward credit and debt.
For example, from the end of 2007 (the eve of the global financial crisis) to the end of last year, the stock of US household debt, as a percentage of US GDP, fell from 101% to a quarter. In particular, that decline in household debt to 77% of GDP occurred despite prolonged periods of extremely low interest rates, contrary to expectations.
In part, it was the response of American households to large-scale dislocations in housing, labor, and financial markets during the financial crisis and subsequent recession. But credit decisions were important. Banks and other mortgage lenders have tightened credit standards, for example, all but removing “subprime” from the home-lender vocabulary. Adjustable-rate and interest-only mortgages are all but gone, with borrowers turning to long-term, fixed forms of home financing. The home-equity loan market has also lagged behind.
In short, prudence and restraint—by both borrowers and lenders—reduced the accumulation of household debt to income and the use of longer-term, fixed-rate loans. As a result, housing debt today is less sensitive to interest rate fluctuations than it was before the financial crisis.
Over the past 15 years, the amount of money Americans have to set aside to service their debt has decreased. The household debt service ratio has steadily fallen from 13.2 percent of disposable income in 2007 to 9.6 percent in the first quarter of 2023. While falling interest rates are important to that effect, they account for only a fraction of the debt decline. – Service costs. After all, while the Fed has raised rates by five percentage points over the past 18 months, household debt service costs have risen by just 1.5 percent of disposable income. This situation would be much lower if that total debt stock had been at pre-2008 levels and the fraction of fixed-rate loans had not declined so rapidly.
For business, the same is true if more moderate variables are also observed. Before the financial crisis, total U.S. corporate debt securities and loans, as a share of GDP, peaked at 45 percent. Today, that figure is 43 percent. Corporate debt as a share of corporate net worth is now at a 50-year low. It’s the opposite of what one might expect, with extremely low interest rates from 2010 to 2022 and strong credit opportunities in the corporate bond and personal loan markets during those years. On average, the data suggest that corporate borrowing has been restrained, rather than excessive, in recent years.
Since 2008, the advanced average maturity of business credit has also been extended. That partly reflects the disappearance of short-term commercial paper markets during the financial crisis, replacing a greater reliance on long-term bond issuance. That was a logical corporate finance response to the significant transition and liquidity risks companies were then facing.
Overall, debt servicing costs for the corporate sector are likely to rise over time due to higher interest rates, but the squeeze between higher rates and corporate cash flows is likely to be greater than in previous cycles.
The biggest increase in debt in the last fifteen years is in the public sector. U.S. government debt will nearly double from 64 percent of GDP in 2007 to 120 percent by the end of 2022.
But unlike the household and corporate sectors, the US federal government is not cash-strapped. Higher debt levels and even rising debt service costs, alone, can lead to credit problems by creditors or rapid policy shifts that reduce government deficits and debt.
The evidence for the former is clear. While the Federal Reserve has raised short-term rates by 500 basis points over the past 18 months, long-term lending rates have only increased by 350 basis points. (The basis point is one hundred percent.) Despite rising government debt and debt servicing costs, private sector demand for US debt securities remains strong and unyielding.
As for policy, divided government in a polarized political environment all but ensures the continuation of the status quo, with no major policy legislation passing Congress and becoming law. Accordingly, sudden or sharp fiscal consolidation seems highly unlikely until the 2024 elections, at first.
So, is soft-landing guaranteed?
No, things can still happen. But the risk of a hard landing is waning due to a worsening Fed tightening. Mainly, that’s because inflation is finally going as far as most economists think. But it is the contributing US economy that is more resilient to higher interest rates than many think.
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