Recession, recession, recession, the fight song of the past year. Yet, no recession is in sight. For the second quarter, GDP (Gross Domestic Product) just surprised on the upside again. Concurrently, the Fed just hiked interest rates once more, to a policy rate of 5.25% to 5.5%. However, the economy is better off by many measures than when the Fed Funds Rate was pinned at 0%. And as I write this, GDPNow just released an estimate of 3.9% growth for the third quarter, implying that the economy is growing at an increasing rate. This outcome defies economic logic and has blown away the near-unanimous predictions of a recession. How can this be happening?
Strange condition: Real GDP improving as the Fed Funds Rate increases
Source = FRED
Why has the Fed not been able to slow the economy?
Raising the Fed Funds Rate to cool inflation is centered around the belief that higher interest rates will curb demand. Consumers will shy away from big-ticket spending, and businesses will reduce investment, expansion, and capital expenditures. Less demand leads to less inflationary pressure.
In general, businesses and consumers borrow long and save short. As the Fed has raised the Fed Funds Rate from 0% to 5.5%, savers in money market-type funds have received a material raise. At the same time, interest rates on longer-dated loans have not risen as much, allowing borrowing costs to remain relatively low. The spread between the savings yield and the fixed long-term borrowing rate has actually narrowed to near the lowest spread in 20 years.
Savings yields have risen more than the increase in borrowing costs
1/1/2009 (start of Zero percent interest rate policy to June 01, 2020, Fed Funds Rate as a proxy for the savings rate, 30-year average mortgage rate as a proxy for the cost of long-term fixed rate borrowing cost.
The idea that an increase in the Fed Funds Rate helps savers is only relevant if an excess of savings is built up in the economy. Consumers and businesses appear flush with cash, about 5.7 trillion dollars’ worth now earning about 5% yield.
Flush with cash
20 years ending June 8, 2023
Who holds all this cash? No surprise here; the older the cohort, the more net worth they have. And the older the population gets, the greater the savings. Alternatively, those with very little net worth are the borrowers. The same holds true for businesses; the more money they have, the less likely they are to borrow. Therefore, the benefit of a higher Fed Funds Rate is received by those with the most money, who feel little impact of higher borrowing costs.
Distribution of Net Worth
Note: Distributions by generation are defined by birth year as follows: Silent and Earlier=born before 1946, Baby Boomer=born 1946-1964, Gen X=born 1965-1980, and Millennial=born 1981 or later.
The Fed has managed to raise borrowing costs, but they have raised the return on savings by a greater amount. If an economy is flush with cash, and those with the cash are not borrowers, the higher the savings yield relative to the borrowing rate, the less impact rising interest rates should have.
Is the Fed helping the economy by raising the savings yield? In some ways, maybe, but probably not overall. The robust economy we are experiencing is being attributed to a confluence of other factors, such as plentiful jobs, rising asset prices, excess savings that the San Francisco Fed expects will, “…continue to support consumer spending at least into the fourth quarter of 2023.” and finally, wage growth that has now exceeded inflation for the first time in years. As I write this, though, it feels like there is something mysteriously different this time around. Either way, so far, it appears the Fed is not slowing the economy at all.
So, what’s the risk?
While a recession is a fading risk that is being pushed into the future, it is starting to feel like the unpriced risk is quite the opposite. What if the economy is stronger for longer?
The ‘soft landing’ economic scenario of tepid inflation and a slowing economy implies that the Fed will soon pause and start cutting rates. However, the economy doesn’t seem to be landing; it might be taking off. This is, of course, a good thing if inflation continues its disinflation path to the target rate of 2%. Currently, core inflation is hovering near the 5% mark.
A ‘stronger for longer’ economy could pressure inflation to remain higher than desired and require the Fed to hold the Fed funds rate near 5% or even to continue to tighten.
As the Fed has raised interest rates, the yield curve has only become more inverted, which keeps longer-dated borrowing costs low relative to the savings rate. Under a ‘stronger for longer’ outcome, longer-dated interest rates – those that are determined in the marketplace – could be pressured upwards. And this is when the economic damage could become apparent.
If longer-dated borrowing costs were to rise, bondholders would see losses, and consumers and businesses could face materially higher borrowing costs. It might be only then that we need to be concerned about the economy. But let’s not confuse possible and probable. I am not sure investors are considering this outcome a high probability, which makes this outcome a possible unpriced risk.
- The economy appears quite strong in the face of rising interest rates.
- One reason the Fed has not slowed demand might be the narrowing spread between the savings rate and the borrowing rates.
- It appears unlikely that the Fed will lower interest rates while the economy is strong, inflation is sticky, and employment is strong.
- A new possible risk now appears to be a ‘stronger for longer’ economy. Under this scenario, it is yet to be seen if inflation can maintain its disinflationary trajectory. The Fed may have to continue to raise rates for the foreseeable future.
- The longer ‘stronger for longer’ goes on, the greater the chance that longer-dated interest rates could rise.
- It may only be then that higher borrowing costs become more universally felt, and the economic impact could be material.
- It’s a good thing that the economy is robust. I am just not sure anyone expected an outcome this good.
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Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
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