Is the US Economy More Resilient to Interest Rate Hikes Than We Think?

　　The market is cheering on the prospect of a “soft landing” for the U.S. economy. Stock and bond markets have risen strongly recently. Better-than-expected consumer price index (CPI) and producer price index (PPI) are the catalysts behind the market rise. These data Investors have raised hopes that U.S. inflation can be contained without the economy slipping into recession.
　　For many, the surprise was not the fall in inflation but the resilience of the U.S. economy, whose arrival had long been predicted. Falling prices for oil, food and other commodities have already pointed to a slowdown in overall inflation in 2023, after last year’s price surge related to the Russia-Ukraine conflict. More broadly, it is inevitable that inflation measures will fall year-on-year this year due to last year’s higher comparison base.
　　Temporary shortages of computer chips, new cars and other goods caused by the pandemic are easing, replaced by higher production and lower prices. In addition, the slowdown in housing rental growth in the first half of this year indicates that inflationary pressure in the housing sector is about to ease. Housing prices are the most important component of the US CPI. The overall U.S. CPI will soon fall below 3%, and by this time next year, it is entirely possible that core CPI will fall within the Fed’s 2% target range.
　　While many economists thought inflation would eventually be brought under control, few believed it could be done without triggering a recession. Many economists believe that the Federal Reserve’s sharp interest rate hikes, reductions in fiscal spending related to the epidemic, and sluggish economic growth in Europe, Japan, and China are all insurmountable headwinds for the U.S. economy. The bond market has also sent the strongest signal yet – a deep inversion of the yield curve, which is often a harbinger of a recession.
　　However, recent economic data runs counter to recession fears. Job openings in the labor market continue to grow, and although growth has slowed recently, it is still more than twice the rate of labor supply growth. Consumer spending has proven resilient, and even the housing market, which has been going through a soft phase, is showing new energy.
　　There are of course problems, the biggest of which is commercial real estate, which is struggling as borrowing costs rise and workers are slow to return to the office. Other problems include the drag on U.S. economic activity caused by weak business investment spending and falling net exports.
　　However, what is currently attracting the most attention is the resilience of the U.S. economy in the face of the Federal Reserve’s sharp interest rate hikes (similar measures have also been taken by emerging markets and other advanced economies). We discussed several reasons for the resilience of the U.S. economy in our article “Why Very Low Interest Rates Will Return Again”, including strong consumer spending (supported by increased household savings during the epidemic) and partial replacement by government spending with other forms of spending. This includes the fiscal stimulus during the epidemic (such as the Inflation Reduction Act) and the surprising resilience shown by the euro zone economies in the face of the Russia-Ukraine conflict.
　　But there is another factor that is rarely mentioned in many reports on the U.S. economy: Because of changes in household and corporate debt since the 2008 global financial crisis, U.S. private sector spending may no longer be as sensitive to interest rates as is generally thought. so high. If that’s the case, the Fed raising rates may not weaken demand in the economy as much as it has in the past.
　　Since the global financial crisis, there have been significant changes in the attitudes of U.S. households and creditors toward borrowing. For example, from the end of 2007 (the eve of the global financial crisis) to the end of 2022, the balance of U.S. household debt as a share of U.S. gross domestic product (GDP) fell by a quarter, from 101% to 77%.
　　It is worth noting that the decline in household debt has occurred in an environment of extremely low interest rates for a prolonged period. One reason for the decline in household debt was the disruption in housing, labor and financial markets during the financial crisis and ensuing recession. That’s understandable, but lending decisions are also an important factor, as banks and other mortgage lenders tighten credit standards, all but removing “subprime” from the home loan lexicon, adjustable-rate mortgages and interest-only mortgages have all but disappeared, with borrowers turning to long-term fixed-rate home mortgages and the home equity loan market shrinking.
　　Simply put, the prudence and restraint of both borrowers and lenders has reduced household debt ratios, and more households have chosen long-term fixed-rate loans. As a result, housing liabilities today are less sensitive to interest rate fluctuations than they were before the financial crisis. Over the past 15 years, Americans have also had to set aside less money to pay down their debt. At the end of the first quarter of 2023, the household debt service ratio dropped to 9.6% from 13.2% in 2007.

　　While previously low interest rates were an important factor in the decline in debt service ratios, they are only one factor in the decline in debt service costs. Over the past 18 months, despite the Federal Reserve raising interest rates by 5 percentage points, household debt service ratios have only increased. 1.5 percentage points. If total debt balances were at pre-2008 levels, and if the share of adjustable-rate loans had not declined significantly since 2008, this number would be significantly higher than it is now. A similar but more modest dynamic is occurring in business. Before the financial crisis, U.S. corporate debt securities and loans peaked at 45% of GDP; today they are 43%. The ratio of corporate debt to corporate net asset value is currently at a 50-year low. Considering the era of ultra-low interest rates from 2010 to 2022 and the large number of credit opportunities brought by both the corporate bond market and the private credit market during this period, corporate debt to net asset value Such a low ratio may be counterintuitive to some.
　　The data shows that, on average, corporate debt has been constrained in recent years without becoming over-indebted. The average maturity of corporate debt balances has also increased since 2008, reflecting in part the demise of the short-term commercial paper market during the financial crisis and greater reliance on longer-term bond issuance. This was a reasonable response by the business to the higher rollover and liquidity risks it faced at the time.
　　Overall, while rising interest rates are likely to cause companies’ debt-servicing costs to rise over time, the lag between rising interest rates and a squeeze on corporate cash flows is likely to be longer than in previous cycles. Over the past 15 years, the largest increase in debt has been in the public sector. By the end of 2022, the U.S. government debt-to-GDP ratio has almost doubled from 64% in 2007 to 120%. But unlike households and businesses, federal money is not tight. High debt levels, or even rising debt service costs, by themselves are unlikely to cause lenders to immediately tighten credit or prompt governments to quickly shift to policies to reduce deficits and debt.
　　The evidence for the former is clear. While the Fed has raised short-term rates by 500 basis points over the past 18 months, long-term borrowing rates have only risen by 350 basis points, even as the Fed began to unwind its balance sheet. While government debt and debt-servicing costs continue to rise, private sector demand for U.S. debt securities remains strong, and that is unlikely to change. In terms of government policy, in a polarized political environment, divided government all but ensures a continuation of the status quo, with no major policy legislation passing Congress and being signed into law.
　　Therefore, a sudden or dramatic fiscal consolidation looks extremely unlikely until at least the 2024 presidential election. So, will the U.S. economy inevitably have a “soft landing”? Not so, and worse could still happen. Still, the risk of a hard landing from the Fed’s sharp policy tightening is receding, largely because inflation has finally cooled as most economists expected. But a more important reason for the receding risk of a hard landing is that The U.S. economy is more resilient to interest rate increases than many people imagine.