Interest rates have risen quickly over the past 18 months, and while inflation is cooling, it hasn’t seemed to slow consumer spending all that much.
While this is typically good news for the economy, increased spending is actually a bit of a problem right now. The Fed expects spending to slow as they continue to raise rates. If it doesn’t, they might continue their assault on inflation by continuing to raise rates.
So the question is how much money do Americans have left to spend before the economy cools off and the Fed backs off their rate-hiking policy? Let’s explore.
US Households Keep Spending Money
According to a recent report by the Commerce Department, retail spending was up 0.2% year-over-year, and up over 1.6% in Q2 compared to last year. This increased spending is happening even with interest rates up nearly four times since the previous year.
This means that U.S. households continue to spend, even with mass tech layoffs, huge cost increases for home and auto loans and continued high costs at retail locations. Since personal spending accounts for nearly 70% of the U.S. GDP, this means that a recession is on hold until spending subsides.
This might seem like good news, but since the Fed is trying to curb inflated prices, it’s hard to do this as consumer demand is always there to pay those prices. According to the Consumer Price Index (CPI) data, inflation is slowing (only up 3% between June 2022 and June 2023), but spending is still strong all the way around.
How Much Money Do Americans Actually Have Left?
Part of this continued spending can be attributed to the unprecedented amount of stimulus money injected in the U.S. economy in the wake of the pandemic. At the same time, Americans began saving more money than ever due to pandemic-related closures, boosting savings rates through the roof.
American households amassed nearly $2.3 trillion in savings from 2020 though the summer of 2021, according to the Federal Reserve. While normal savings rates were around 8.5% prior to stimulus, rates climbed to nearly 27% in 2020. This accounts for over $2 trillion in excess savings, according to a report by the Federal Reserve Bank of San Francisco.
This same report also states that while households accumulated nearly $2.1 trillion in excess savings, they’ve only spent about $1.6 trillion of it since 2021. This means there may still be nearly $500 billion in excess savings in American bank accounts. The report states that this could buoy the economy until the end of 2023.
What Happens If People Don’t Stop Spending?
If the report by the Federal Reserve Bank of San Francisco is correct, then Americans can continue to keep spending strong through the end of the year. This would keep retail sales strong, prop up the stock market, and continue strong GDP numbers as well.
If this happens, then we may avoid a recession in 2023, but it could pose a huge problem for 2024. Since consumer spending largely informs monetary policy in regards to interest rates, if the Fed sees strong spending and inflation does not drop as quickly as expected, they will continue to raise rates until it does.
The problem is that higher rates means business growth slows, which can lead to layoffs. Higher rates also means higher mortgages and auto loan costs, as well as an increase in other borrowing costs.
And if rates are bumped up too high to further squash inflation and slow spending, it could be a fast drop for the economy.
Rates might be pushed higher than needed, and as this excess $500 billion dries up, the economy will be forced to contract. This could mean a significant decline in GDP (which might lead to an economic recession), a big uptick in unemployment and possibly even deflation.
Are We Headed for a Recession?
An economic recession is defined at two consecutive quarters of negative GDP, or a reduction in economic growth. This already happened in the first two quarters of 2022, but no one wants to officially label it a recession.
If rates continue to rise and Americans finally run out of the excess stimulus savings money, then we could be headed for a larger recession. With credit tightening for businesses around the globe, housing becoming more unaffordable and the Fed poised to raise rates even further, a contraction in growth is likely.
The Federal Reserve Board of Governors believes the excess stimulus savings is already accounted for in their latest report, so their rate hikes may not be considering this possibility.
Either way, the effects of going from a zero interest rate policy to over 5% rates is already having an effect on inflation and businesses. But at what point does this credit tightening push us into an official inflation? Only time will tell.
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