4 Factors Have Kept the Economy Strong. 3 Are Fading.

True, if economic data continue to come in strong, the Fed may hike every other meeting, meaning in July and maybe even November, as the Fed’s economic projections suggest. But in the context of a hiking cycle in which the Fed raised rates by 5%, an additional quarter-point or two hardly matter.

Moreover, the Fed believes the inflation-adjusted rate of interest consistent with neutral policy is still around 0%. Real yields on one-year U.S. Treasury bills are now roughly 3% over inflation expectations embedded in the swap market. Last decade, it was common for yields to run about 1% below those inflation expectations. In other words, policy has become quite restrictive.

And yet, the economy has seemed quite strong. Recession callers have been frustrated for a year at its resilience in the face of the historic rise in rates. If higher rates are a powerful weapon trained on the economy, there have been a number of unusual factors that have shielded it from their damage. But that shield may now be weakening, potentially leaving the economy vulnerable to high interest rates. Of four prominent supports for the economy, three seem to be wearing off. As these supports ebb, the Fed is likely to stop hiking and wait for the effects of higher rates to finally kick in.

First, as a result of trillions of dollars of new federal spending during and after the end of the pandemic recession, households accumulated over $2 trillion of excess savings above their pre-Covid trend. The combination of direct checks from the government, soaring asset prices, and booming business led to a surge in bank account balances that has buttressed consumer spending. 

However, inflation has far exceeded wage growth, and households’ real incomes have shrunk. Real wages are about 4% below where they were at the end of 2020. Consumption has grown while real earnings declined, whittling down those stockpiled savings. Research by the San Francisco Fed indicates excess savings could be exhausted this summer. Savings depleted, the decline in real incomes will take its toll as households start to cut their expenditures. 

Second, fiscal policy has continued to underpin growth, particularly in interest-rate-sensitive sectors like construction. Billions of government dollars flooding into infrastructure, semiconductor facilities, and climate tech have caused nonresidential construction spending to explode to all-time highs. 

However, fiscal policy will soon turn from tailwind to modest headwind for the economy thanks to the bipartisan legislation that also raised the debt limit. Under the Fiscal Responsibility Act, student loan repayments are slated to resume at the end of August. That will drain about $5 billion per month from consumers’ budgets—potentially at the same time excess savings run out. Limits to nondefense discretionary spending mean overall government outlays will grow more slowly than nominal gross domestic product, exerting a real drag on the economy. 

Third, at the start of the year, because of the Fed’s “abundant reserves” monetary framework, most banks still faced upward-sloping yield curves, despite the inverted yield curve in the Treasury market. This matters because banks borrow short (deposits) and lend long (loans). When short-term yields exceed long-term yields, banks find credit creation unprofitable, dragging on growth. But with most banks still offering deposit yields close to 0%, banks’ yield curves sloped up, and credit growth was healthy. 

Since the bankruptcy of Silicon Valley Bank, this has changed. Yields of 5% at money market funds have lured deposits away, forcing many banks to raise deposit yields to remain in business, impeding the extension of bank credit into the economy. Commercial and industrial loans, particularly important for smaller businesses that can’t access bond markets for credit, peaked in February and have been declining since. 

Finally, peculiarities of the housing market make it unusually resistant to interest rate hikes in this cycle. Typically, the large and volatile housing sector is a key monetary transmission path into the economy, and layoffs from homebuilders accelerate quickly. 

But presently, the lag from housing start to completion is significantly greater than usual, meaning workers are still building projects from a while ago. And while housing may have been in undersupply even before Covid, shifting migration and homeownership patterns since the pandemic seem to have caused severe undersupply in some areas. Finally, interactions of the tax code with inflation mean that real, after-tax mortgage rates haven’t increased as much as the nominal rate. 

Higher mortgage rates will eventually catch up with the housing market, but maybe not very soon. If they do, workers shed by residential builders have alternatives in booming government-subsidized nonresidential construction. 

With the monetary-transmission system effectively clogged, higher rates weren’t transmitting into the economy. But now those blockages seem to be resolving. Three of the four principal pillars of the economy’s resilience seem to have eroded, leaving construction employment a redoubt of strength. Nobody knows if it will be enough, but increased rate transmission into the economy is likely to give the Fed pause. 

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