By Senior Economic Advisor, Dr. Alan Greenspan
Despite widespread reports of inflationary pressures abound, the American consumer has continued to buttress the U.S. economy as the economic upheaval caused by the COVID-19 pandemic fades further into the past of our collective memories. Households had enjoyed a Goldilocks period in the aftermath of the pandemic in which low rates, depressed prices, and government relief payments allowed many to get their financial houses in better shape than before the outbreak of COVID-19. The proliferation of vaccines and boosters, coupled with a decrease in the virulence of each new variant of the virus, meant businesses could increase capacity just when cooped up consumers had money to spend. Their
resiliency going forward will play a large role in determining whether the Federal Reserve can engineer the soft landing so many market participants are hoping for.
To be sure, the job market remains tight and as a result wages continue to rise. But as far as the consumer is concerned, the good news seems to end there. As the economy returns to normal, so too must financial conditions, and the days of low rates, bargain-priced services, and plentiful goods are coming to an end in many areas of the economy and already past expiration in others. The Personal Income and Outlays release for April from the Bureau of Economic Analysis revealed the first cracks in the consumer engine resulting from this normalization process. The personal savings rate (personal saving as a percentage of disposable personal income) has reached its lowest level (4.4%) since September 2008. Spending rarely keeps up with unexpected surges in income, let alone the massive amounts of pandemic relief subsidies, and it is no surprise the savings rates rose as consumers battened down the hatches in the face of pandemic uncertainty. As pandemic angst recedes, emboldened consumers are increasingly willing to dip into their aggregate $4 trillion of excess savings to maintain their standard of living in the face of higher prices.
To be fair, the savings rate as well as the additional amount saved per quarter have been in decline for the past year and there is no mystery as to the cause. The oft-quoted “core” Consumer Price Index (CPI) is up 6.2% over a year ago in April. Furthermore, the core CPI excludes the prices of two volatile components – food and energy. However, as I’ve yet to encounter an individual who does not consume food or energy, nor does the real economy make such a distinction in its functioning, I believe the CPI for all items is a better indicator of the headwinds currently confronting the consumer during this inflationary period – it is up 8.3% over a year ago in April. Despite the brisk decrease in consumer purchasing power, real personal consumption expenditures have held up rather well so far, registering an average growth rate of 2.5% in each of the last three quarters. However, consumers will begin to bear an additional weight in the months to come – not to their income statements, but to their balance sheets.
Having disabused themselves of the notion that earlier pockets of inflation might prove transitory, the Federal Reserve is now determined to tamp down price pressures before inflation gets out of control. The Federal Open Market Committee (FOMC) raised the federal funds target rate by 50bps at their May meeting and have signaled that more 50bps hikes will follow until a substantive decline in inflation is evident. They also detailed plans for reducing their near-$9 trillion balance sheet by ceasing to reinvest portions of the proceeds from its Treasury and mortgage-backed securities holdings beginning on June 1. These dual actions work in tandem to drain the financial system of excess liquidity and will result in higher interest rates as the supply of money is reduced.
Interest rates can be understood as the price of money – the price you must pay tomorrow to access money today. When, for example, the price of lumber goes up, the demand for lumber goes down. When the price of money (interest rates) goes up, the demand for everything tends to become depressed because the price of consuming today has become more expensive in terms of forgone future returns. The prices of long-lived assets are especially sensitive to interest rates because their present values are determined in large part by the rate at which future cash flows are discounted back to the present. And so, as the Federal Reserve begins to withdraw the punchbowl of easy money, the “everything bubble” that has seen appreciation in nearly every asset class – from companies near the brink of collapse at the onset of the pandemic, to high-growth tech companies, to cryptocurrencies and NFTs – will begin to deflate.
Asset price gyrations have a profound effect not only on financial markets and financing but on the real economy as well. Capital gains and losses are key factors in the ups and downs of the business cycle. Most pronounced is their effect on consumer spending. The historical data strongly support the view that a rise in the market value of stocks held, for example, in 401k pension funds through contributions or quasi-permanent capital gains will induce households to spend part of their gains on personal consumption expenditures. The value of homes, the largest asset holding for many consumers, also contributes to this “wealth effect” on consumer spending. The stock market has already flirted with bear market territory this year in response to the Federal Reserve’s new course for interest rates. Home prices have held up so far, but with the rate on a 30-year fixed rate mortgage already having increased to 5% (from 3% at the end of last year) it remains to be seen how long buyers can support the housing market. Higher rates coupled with an increasingly pressured consumer pose real risks to what has been a remarkable recovery so far.
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