ATFX - Why didn't sharp interest rate hikes cause the US economy to decline?

atfxMarkets cheered on the prospect of a "soft landing" for the US economy, with strong gains in equities and bonds last week, catalysed by better-than-expected consumer and producer price indices, which have raised hopes among investors that US inflation can be contained without a recession.

For many, the surprise was not the decline in inflation, but the resilience of the US economy, whose peak had long been predicted.

After last year's spike in prices related to the conflict between Russia and Ukraine, declines in oil, food, and other commodity prices have long presaged a slowdown in headline inflation in 2023. More broadly, due to last year's high base of comparison, year-on-year declines in inflation indicators are inevitable this year. Temporary shortages of computer chips, new cars, and other goods caused by the epidemic are easing, replaced by higher output and lower prices. Moreover, housing rental growth slowed in the first half of this year, indicating that inflationary pressures in the housing sector are about to ease, housing prices are the most important component of the U.S. CPI.

The overall US CPI will soon fall below 3%, and by this time next year, it is entirely possible that the core CPI will fall within the Federal Reserve's 2% target range.

While many economists had assumed that inflation would eventually be brought under control, few believed it could be done without triggering a recession. Many saw sharp interest rate rises by the Federal Reserve, a reduction in epidemic-related fiscal spending and sluggish growth in Europe, Japan and China as headwinds that the US economy could not overcome. The bond market also sent the strongest signal yet - a deep inversion of the yield curve, often a harbinger of an impending recession.

However, recent economic data run counter to recession fears. Job creation in the labour market continues to increase, and although it has slowed recently, it is still growing at more than twice the rate of the labour supply. Consumer spending has proved resilient and even the housing market, which has gone through a weak phase, is showing renewed dynamism.

There are, of course, problems, the biggest of which is commercial real estate, which is struggling because of rising borrowing costs and the slow pace of returning workers to the office. Other problems include weak business investment spending and falling net exports, which weigh on US economic activity.

However, it is the resilience of the US economy in the face of the Federal Reserve's sharp interest rate hikes, which have been followed by similar moves in emerging markets and other advanced economies.

In Why Extremely Low Interest Rates Will Return, we discussed several reasons for the resilience of the US economy, including strong consumer spending (supported by rising household savings during the epidemic), the partial replacement of epidemic fiscal stimulus with other forms of government spending (such as the Inflation Cuts Act), and the surprising resilience of eurozone economies in the face of the Russian-Ukrainian conflict.

But there is another factor that is rarely mentioned in much coverage of the US economy: US private sector spending may not be as sensitive to interest rates as is widely believed because of changes in household and corporate indebtedness since the 2008 global financial crisis. If so, Fed rate hikes may not dent demand in the economy as they have in the past.

Since the global financial crisis, the attitudes of American households and creditors towards borrowing have undergone significant changes.

For example, from the end of 2007 (on the eve of the global financial crisis) to the end of 2022, the balance of household debt in the United States fell by a quarter, from 101% to 77% of GDP. Notably, the decline in household debt occurred in an environment where interest rates were very low for a long time.

While it is understandable that one of the reasons for the decline in household indebtedness was the housing, labor, and financial marekts of the financial crisis and subsequent recession, lending decisions were also an important factor, as banks and other mortgage lenders tightened credit standards, virtually removing "subprime" from the lexicon of home loans, adjustable-rate mortgages and interest-only mortgages all but disappeared, borrowers switched to long-term fixed-rate home mortgages, and the home equity loan market shrank.

Simply put, the caution and restraint of both borrowers and lenders has reduced household debt ratios, and more households have opted for long-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, Americans have also had less money to set aside to pay down debt. Household debt service ratios fell to 9.6% at the end of Quarter 1, 2023, from 13.2% in 2007. While previous low interest rates were a significant factor in the decline in debt service ratios, they were only one of the reasons for the decline in debt service costs. In the past 18 months, while the Federal Reserve has raised interest rates by 5 percentage points, household debt service ratios have only increased by 1.5 percentage points. If total debt balances were at pre-2008 levels, and if the share of adjustable-rate loans had not fallen significantly since 2008, this number would be significantly higher than current levels.

Corporate dynamics are similar, but more moderate. Before the financial crisis, US corporate debt securities and gross loans peaked at 45 per cent of GDP; today they stand at 43 per cent. Corporate debt as a share of corporate net asset value is now at a 50-year low, and given the era of ultra-low interest rates from 2010 to 2022, and the abundance of credit opportunities in both the corporate and private credit markets during this period, such a low ratio of corporate debt to net asset value may be counterintuitive to some. The data show that, on average, corporate debt has been constrained in recent years, rather than over-leveraged.

The average maturity of corporate debt balances has also increased since 2008, partly reflecting the demise of the short-term commercial paper market during the financial crisis and a greater reliance on longer-term bond issuance. This was a reasonable response to the higher rollover and liquidity risks companies faced at the time.

Overall, while rising interest rates may cause companies' debt service costs to rise over time, the lag between rising interest rates and a tightening of corporate cash flow may be longer than in previous cycles.

The biggest increase in debt over the past 15 years has been in the public sector, with US government debt almost doubling from 64 per cent of GDP in 2007 to 120 per cent by the end of 2022.

But unlike households and businesses, the federal government is not cash-strapped. High debt levels, or even rising debt-servicing costs, are not in themselves likely to cause lenders to tighten credit immediately. Nor are they likely to prompt a swift shift to deficit and debt reduction policies.

The evidence for the former is clear. While the Fed has raised short-term interest rates by 500 basis points over the past 18 months, long-term borrowing rates have risen by only 350 basis points, even as the Fed has started to shrink its balance sheet. Despite rising government debt and debt service costs, private demand for US debt securities remains strong, and that is unlikely to change.

In terms of government policy, in a polarized political environment, a divided government can all but ensure the continuation of the status quo, with no major policy legislation passing Congress and being signed into law. As a result, sudden or significant fiscal consolidation looks highly unlikely, at least until the 2024 presidential election.

So, is the US economy bound to have a "soft landing"?

Not really. Worse is still possible. But the risk of a "hard landing" for the economy as a result of the Fed's sharp tightening is receding, largely because inflation has finally cooled, as most economists had expected. But a more important reason for the receding risk is that the US economy is more resilient to rate rises than many thought.