Bursting the Pandemic Bubble: Rate Hikes and the Consumer
Consumers plan to spend more time than money with loved ones this season.
“…it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity – the very outcome we would be seeking to avoid.”
I was in the audience when former Federal Reserve Chairman Alan Greenspan defended the Fed’s strategy of cleaning up after bubbles burst. It was August 2002. The internet bubble had burst. The economy was still struggling to generate jobs long after the 2001 recession had ended.
Fast forward 20 years and his words seem both prescient and omnipresent. Rapid rate hikes are deflating the pandemic-induced bubble in housing and goods. We bought a lot of stuff, to alleviate the monotony of quarantines, that we no longer want. Used boats and jet skis are widely available for resale.
This edition of Economic Compass takes a closer look at the consequences of rate hikes and the fallout for consumer spending and inflation. The slowdown in spending thus far has failed to derail inflation, which has moved the goal posts yet again on peak rates for the Fed. Chairman Jay Powell was clear at his last press conference that he intends to “stay the course until the job is done,” even if that means a higher peak in rates and a recession.
Bursting bubbles is a messy business. The drop in home values and rents could be substantial and accelerate the cooling of inflation. This is not a repeat of the 2008-09 subprime crisis in housing, when the drop in home values pushed millions of mortgages underwater. Lending standards have tightened considerably; the cushion on equity is expected to remain substantial.
Peak Growth in the Third Quarter
Real GDP rose by 2.6% in the third quarter after contracting during the first two quarters of the year. An improvement in trade more than accounted for that gain: Exports accelerated while imports plummeted. Domestic demand came close to stalling out. Consumer spending slowed, housing cratered and retailers began to drain bloated inventories. Business investment and government spending rose modestly.
Real GDP is expected to slip back into the red by 0.8% in the fourth quarter. A pickup in spending on services is expected to offset another drop in spending on goods, while a drop in mortgage applications suggests even larger losses for housing and business investment. In September, core factory orders fell at the fastest pace since April 2020. The trade deficit could improve with a drop in imports offsetting a smaller decrease in exports. Government spending is poised to flatline.
Real GDP is forecast to fall at an average 2.5% pace in the first half of 2023 as the effects of rate hikes cumulate. The collapse in housing is expected to spill over to consumer spending. Businesses are expected to pull back and draw down excess inventories. Both exports and imports are expected to fall. Government spending will rise slightly with the largest inflation-adjusted boost to social security in decades, some rebuilding due to Hurricane Ian and a rise in automatic stabilizers. Infrastructure projects are beginning to ramp up.
Why Target Employment?
Inflation continued to accelerate in 2022 despite a significant slowdown in growth. The largest, single reason for the persistence of inflation is the unyielding strength in the job market.
The economy generated 4.1 million jobs between January and October, nearly double the annual pace of the 2010s and the second largest increase since 1978. Only 2021 was more robust. That is a stunning number of new paychecks coming on line to buoy aggregate demand and, by extension, inflation.
When job openings rebounded in late September, the ratio of job openings to unemployed, a closely watched measure by the Fed, jumped to 1.9. That is the second highest ever. Labor turnover slowed, which tempered wage gains but not enough to slow the upward pressure on core (nonfood and energy) inflation.
Productivity growth has plummeted, which is also raising unit labor costs. The drop in the first three quarters of 2022 represented the worst since 1982.
The only way the Fed can be sure to derail inflation given those shifts is to cool labor demand below the level of labor supply. That now means hammering demand, while simultaneously raising the supply of workers via an increase in unemployment.
Chart 1: Excess Saving Still Substantial
U.S. Quarterly Saving, Billions of Dollars
Source: KPMG Economics, Bureau of Economic Analysis
Further complicating the Fed’s job is the excess savings that consumers amassed during the pandemic. That hit an estimated $2.4 trillion peak in late 2021 and fell to $1.8 trillion in the third quarter, which is still substantial. (See Chart 1.)
The problem is the composition of what is left; it is now more concentrated in higher income households than it was at the start of the year. Data in the second quarter revealed that households in the lowest income quintile drained those excesses. (See Chart 2.)
The most recent household pulse survey suggests stress moved up the economic food chain over the summer. More than 40% of households were having a “somewhat or very difficult time covering usual household expenses” in late October. That was the highest share reporting such stress since the survey’s inception in August of 2020.
Other factors buoying demand are credit card usage, which rebounded after plummeting during the pandemic. I see that more as a sign of economic stress than strength. Costs of carrying higher credit card balances will compound rapidly as rates rise.
Defaults and delinquencies remain low but the data lag. The higher cost of debt will no doubt add to the pinch that the bottom 40% of households is feeling.
The last of government-sanctioned loan forbearance is slated to expire on January 1, 2023. Student loan payments, which were put on ice during the pandemic, will need to be serviced again. Student loans have the highest rate of default of any loan category. The administration’s proposed $400 billion in student loan forgiveness remains snarled in the courts.
Whatever your views on that policy, there is little doubt it would alleviate the upward pressure on delinquencies and defaults. My own view is that student loan forgiveness does not solve the problem of soaring tuition costs.
I take issue with estimates that forgiveness will spur inflation. Students who were able to delay loan payments for more than two and a half years have already adjusted their monthly expenses to reflect what they would have spent on student loans.
To add insult to injury, household net worth has been decimated. The blow to the value of financial assets was $7.3 trillion in the second quarter, the largest decline since 1946. We estimate another $2 trillion loss for the third quarter. (See Chart 3.)
Nearly every poll reveals most Americans believe the economy is either in or on the cusp of a recession.Those who had jobs at the start of the year have lost all that they gained in raises, and then some, to inflation; they experienced an erosion in living standards.
That does not rise to the bar of what economists define as a recession but nonetheless feels like one. In response, consumers are expected to prioritize seeing their loved ones in person instead of shipping them gifts under the tree this holiday season.