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The US economy has been in a disinflation phase since the middle of last year. While this has supported consumer spending in recent months, the banking crisis will likely tighten credit beyond what was already baked into the system from cumulative tightening by the Federal Reserve (Fed). Prior episodes of banking stress have seen central banks change course. This time, some Fed members are suggesting caution, but others believe inflation is still much too high and want to tighten policy further. No one on the Federal Open Market Committee is actually talking about easing policy this year, although the bond market has priced in cuts.
Consumer purchasing power and confidence have been edging higher since inflation peaked in 2022, though progress has been slow and uneven, with inflation remaining relatively high for necessities such as food and shelter. I expect that disinflation will be strongest through the middle of this year as elevated food and energy prices normalize.
A key factor in the inflation story has been the rotation toward service consumption and away from goods consumption over the past year. The service economy, and especially travel, leisure, and hospitality, got a boost from consumers over the course of last year as pandemic restrictions were eased. At the same time, consumers pulled back on goods spending after a surge in demand during the pandemic, leaving an inventory bulge. The goods economy has since made tremendous progress working off the surplus inventory, and while there are still pockets of adjustment taking place, this process looks to have largely run its course. In terms of the inflation impact, the contribution of core goods prices to the CPI is virtually zero, with several categories seeing outright declines. Later this year, disinflation will rely more on service prices growing more slowly than in the recent past.
With banks under stress, consumers also appear to be reassessing the probability of job losses. This caution has manifested itself in a rising savings rate even as current incomes have grown at a solid clip. In the second half of the year, I expect softer job readings as companies cull excess labor and the cumulative impact of Fed tightening bites. That said, a defining feature of this economic expansion has been tighter labor market conditions as baby boomers begin to retire. This could mean more labor hoarding than history would suggest.
As a result of the recent debt ceiling deal, the second half of the year will also bring renewed student debt payments, which had been paused under a pandemic moratorium for more than two years. While these challenges will affect consumers, it is worth noting that the average household balance sheet is quite strong and less interest rate sensitive than in the past thanks to a higher share of fixed-rate mortgages in the consumer portfolio.
Disinflation has also been welcome news for many companies that have seen input cost pressures ease from previous highs driven by supply chain bottlenecks. On the flip side, higher interest rates and less pent-up demand have translated into normalization of pricing and even price cuts in some areas. At an aggregate level, profit margins of S&P 500 companies have come back to pre-pandemic levels. Given much higher interest rates compared with recent years, as well as slow growth, margins could come in further.
In terms of investment spending, funding from the Inflation Reduction Act (IRA) and the CHIPS Act has buoyed nonresidential construction spending, with many new factories being built to facilitate the energy transition. State and local spending in these areas has also helped the economy. But equipment investment has seen pressure from the technology front, where the pandemic-era boom in personal computers and other technology equipment has faded over the last couple of quarters. More broadly, investment spending is likely to bear the brunt of the impact from credit tightening as banks become more cautious in their lending behavior. Commercial real estate, including office space and multifamily residential starts, is likely to come under pressure and see meaningful pullbacks. Broad-based tightening of credit standards suggests that the 2024 – 2025 outlook for construction spending overall has dimmed.
It is worth emphasizing that there is uncertainty about the pace at which the economy as a whole will feel the impact of tighter lending standards. This has to do with the strong starting point of many corporate balance sheets, as well as the smaller share of lending that is attributable to the banking system — especially the smaller banks that are under pressure. Dispersion of results is to be expected in such an environment. Looking further out, the reindustrialization efforts made possible by the tax credits under the IRA and the CHIPS Act serve as important medium-term positives for the US economy. In addition, overseas economies are recovering from COVID lockdowns, which should boost export growth for the US and help to keep the US dollar in check.
From a policy standpoint, Congressional action on the debt ceiling addressed a major area of uncertainty. In the coming weeks, all eyes will be on the Supreme Court’s decision on student debt forgiveness, given the impact on the US budget deficit and the lives of so many borrowers.
Both Congress and the Fed will be in the spotlight as they assess possible measures for stabilizing the situation for smaller banks. Proposals include broader FDIC deposit coverage and rule changes that could improve the liquidity situation of these banks. Eventually, the difference in interest rates paid by banks relative to some mutual funds (nonbank assets) will create enough tension to require a narrowing of the gap. Bank incomes will be under pressure, making banks more reluctant to lend as they raise deposit rates to keep money within the system.
With the banking problems as a catalyst, the Fed signaled at its May meeting that it would consider a pause in its rate-tightening cycle to assess the impact on the economy, and also noted that increased credit tightening could do more of the heavy lifting in the effort to slow inflation than is currently understood. (It is important to keep in mind that real rates will rise for the economy if the Fed pauses rate hikes and disinflation continues.) The Fed has also been conducting quantitative tightening for some time and it is plausible that later this year it will signal a shift in this policy.
The banking situation has increased the uncertainty around the future path of growth for the US economy. Tighter credit, especially for small businesses, which account for about 70% of job openings today, suggests looser labor market conditions ahead. At the same time, disinflation is proceeding so that toward the end of the year, the Fed should have room to ease policy. In short, unemployment is low today and inflation high, but the picture could look different by the end of the year.
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By
Andrew Heiskell
Nicolas Wylenzek