Lower Inflation Yet Robust Growth: Unpacking the U.S. Economic Paradox in the Post-Pandemic World
How did Fed's record rate hikes lower inflation without stalling GDP growth?
In April 2022, the Bureau of Labor Statistics reported a CPI increase of 8.5% for March 2022, marking the highest inflation rate the U.S. had seen since 1981. Despite this surge in inflation, the economy showed signs of strength, with an unemployment rate at a near-record low of 3.6% and a GDP growth rate of 3.6%. This combination of high inflation and healthy growth presented a complex challenge for the Federal Reserve, prompting a shift in monetary policy towards inflation control.
In response, the Federal Reserve embarked on a rapid series of interest rate hikes, raising rates from 0% to 5.5% from March 2022 to July 2023. This marked the steepest increase in the Fed's history, leading to widespread speculation among economists about the potential negative impacts on GDP growth and employment rates. The conventional expectation was that such measures to combat inflation would slow economic growth and increase unemployment, possibly even leading to a recession.
However, the outcome defied these expectations. Two years after the start of the interest rate hikes, the economy remains robust. GDP growth is solid at 3.1%, unemployment remains low at 3.9%, wages are rising, and job creation continues apace each quarter. Furthermore, inflation has decreased to 3.2%, approaching the Federal Reserve's target of a 2% long-term inflation rate.
Isn’t this the perfect outcome? Inflation comes down without impacting the growth at all. How did this happen?
There are three reasons:
1. Steady consumer spending: Consumption spending is the most important component of the U.S. economy, contributing ~68% to the GDP. Even in the face of high interest rates, consumer spending has continued to grow at ~2.4% since 2022, consistent with pre-pandemic growth rates. There are three reasons why consumer spending has remained robust –
a. U.S. households dipping into pandemic period excess savings: During the pandemic, the household savings rate in the U.S. escalated from 6% to 10%, buoyed by reduced consumption amid lockdowns and enhanced by governmental financial support. This led to an accumulation of $2.1 trillion in excess savings by the end of the pandemic. These reserves have played a crucial role in sustaining consumer spending amidst inflationary pressures, however only about $0.4 trillion of these excess savings remain today.
b. Strong labor market: The post-pandemic labor market has shown remarkable strength, with unemployment rates consistently below 4% and participation rates for the prime-age workforce reaching a 20-year peak. Wage growth has also seen a significant uptick, from an average of 3% pre-pandemic to 6% thereafter, leading to substantial increases in household disposable income.
c. Fixed-rate mortgage lock-in: In the zero-interest rate policy regime, many American households strategically locked in long-term mortgages, typically for 20 to 30 years, securing low interest rates. This move has shielded them from the impact of current higher interest rates. This is evident from the fact that currently, the effective annual mortgage interest rate is 3.8%, compared to the 6.7% rate that new mortgage borrowers face.
2. Elevated government spending: Government spending as a percentage of GDP, which averaged around 20% between 2015 and 2019, saw a significant increase to ~24% post-pandemic. This heightened government expenditure, particularly in sectors like health, Medicare, and through initiatives like the CHIPS Act and the Inflation Reduction Act, has been instrumental in stimulating the American economy by creating jobs and fostering private investment.
3. Accelerated business investment: Post-pandemic, business investment in the U.S. has seen a notable acceleration, growing at annual rates of 12% and 19% in 2022 and 2023, respectively, compared to an average annual growth rate of 7% from 2010-2019. A significant portion of this heightened growth can be attributed to a surge in manufacturing investments, which increased by a whooping 40% and 75% in 2022 and 2023, respectively. The increase in manufacturing investments has been spurred by government legislation such as the CHIPS Act, Inflation Reduction Act, and the Infrastructure Law. Much of this investment targets areas like renewable energy, electric vehicles, semiconductors, as well as traditional sectors such as ports, highways, power grids, and airports.
While these drivers paint a picture of a resilient and dynamic U.S. economy, this narrative, largely positive, glosses over a more nuanced reality. Beneath the surface of robust growth and strategic investments, certain stresses are quietly brewing.
1. Bottom 50% consumers under strain: The top 50% affluent consumers in U.S. own roughly 95% of all U.S. assets, including nearly 99% of corporate equity and around 90% of real estate. Conversely, the bottom 50% collectively possess only 5% of assets, yet they own 52% of all consumer credit and approximately 25% of home mortgages. This disparity raises a critical question: who truly benefits from the booming stock market, and who bears the brunt of escalating credit costs? It’s the top 50% affluent consumers, benefitting from this growing “wealth effect” and low credit costs, that have accounted for majority share of consumer spending that has kept the economy afloat. Unsurprisingly, the bottom 50% find themselves under increasing financial pressure. Over the past two years, as credit card interest rates soared from 15% to 21% annually, the financial burden on these less wealthy households has intensified. This growing pressure is evident by the massive 35% surge in total credit card loan balances in the last two years, now at $1.1 trillion, and the uptick in credit card balances 90 days or more overdue from 7.7% to 9.7% in the last year alone.
2. Approaching unsustainable levels of govt. debt - The U.S. is nearing a level of government debt not seen since World War II. At the end of 2023, the government owed $26.2 trillion in public debt, hitting a 97% debt-to-GDP ratio. This is the highest it's been since the early 1950s. The Congressional Budget Office (CBO) predicts this will rise even further to 116% by 2034, breaking the previous record of 106% set in 1946. High debt means the government spends more on interest payments, the money it could have spent on more productive sectors of economy like healthcare, infrastructure etc. Think about this - in 2024, the govt. is projected to spend more on interest payments, than on defence and medicare! If this continues, the government will have to cut spending in areas that help the economy grow, which could hurt long-term growth and weaken the U.S. dollar.
3. Mag 7 companies masking broader corporate struggles: Last year, the "Magnificent 7" companies were the driving force behind all the S&P 500's return and profit growth. J.P. Morgan's analysis shows that in 2023, these seven companies saw their earnings jump by 27%. But what about the other 493 companies? Their earnings didn’t grow; they actually fell by 4%. Most of these companies didn't even have to deal with higher borrowing costs. Many S&P 500 companies took advantage of very low interest rates to take on more debt, securing low financing costs that they haven’t had to renegotiate yet, and even started earning higher return on their cash balances. However, things are about to shift. About 25% of the debt held by S&P 500 companies is due to mature in the next three years, meaning they’ll have to refinance at higher interest rates. This mix of earnings challenges and the risk of rising borrowing costs could put a strain on most companies, potentially affecting their investments in growth and, consequently, the broader economy.
What happens next with the growing pressures on consumers, businesses, and the government is still up in the air. Will we see more bad loans? Will smaller companies cut back on investing? And how will the government tackle its growing debt? Time will tell.