Why is the US Economy Resilient to Interest Rate increases?
(This is for information purposes only. This should not be construed as a recommendation or investment advice even though the author is a CFA Charterholder. Please consult your financial adviser before taking any investment decision. Safe to assume the author has a vested interest in stocks / investments discussed if any.)
The US Federal Reserve raised the federal funds rate by 5.25 percentage points in the past 18 months from 0.00-0.25 percent to 5.25-5.50 percent target range.
Monetary policy tends to work with a lag, meaning that the impact from higher interest rates will be felt by households and businesses, not immediately, but over a period of time.
Even after 18 months of unprecedented monetary tightening, the US consumer spending (which accounts for 70 percent of US gross domestic product or GDP) continues to be robust.
However, the US consumer price inflation or CPI has fallen from a peak of 9.1 percent in June 2022 to 3.7 percent now. This is due to a combination of interest rate increases and base effect. So, the US Fed can take some credit for lower inflation rate.
The US companies show no signs of weakness in economic activity. The US unemployment rate is low at 3.8 percent, though it ticked up a bit last month. The US labour market is tight and strong with workers enjoying higher wages.
In April-June 2023 quarter, the US economy expanded at an annual rate of 2.1 percent as per data from the US Bureau of Economic Analysis. It’s expected that the US Fed will keep these interest rates higher for longer.
In this backdrop, what is contributing to the durability of the US economy?
Some possible reasons:
1. Household balance sheets in the US are stronger – in the sense, that US households received big money during and after the COVID-19 Pandemic and they have been using this money for their spending needs.
Both the Trump and Biden administrations have spent huge money by sending checks to US households, as a cushion for the ill effects of COVID-19 Pandemic.
However, the personal savings rate has come down to 3.5 percent (July 2023) indicating the households have used up their savings substantially – this shows that they may face hardship in future once their savings are used up. In addition, if you’re using credit card debt, you’re already facing the full brunt of higher interest rates.
2. The US companies and businesses have stronger balance sheets – when the US interest rates were lower before 2022 and credit conditions were easy, they took advantage of these factors and refinanced their debt for longer term maturities at fixed rates.
Earlier, their debt was for shorter terms – but this changed in the last few years and US companies have been taking debt for longer tenures.
This locking in at lower interest rates has contributed to lower borrowing costs for the US companies. The benefit will continue until the debt needs to be refinanced.
On top of that, many US companies have higher cash surpluses and are being benefited with higher other income from higher short term interest rates in the US.
3. The US is unique in the sense that US households have the advantage of fixed-rate mortgages for 15- or 30-year periods. The fixed rates cushion them from higher interest rates and they enjoy the same monthly mortgage payments even as interest rate started rising since March 2022.
Of course, for those who take new home loans, they have to cough up higher monthly mortgage payments at higher rates.
4. The US economy is more dependent on services sector, like, technology, communication services and healthcare – rather than manufacturing sector. The impact of higher interest rates on such sectors is minimal and they have the capacity to weather interest rate increases.
On the contrary, manufacturing sector is more susceptible to higher interest rates. And manufacturing sector accounts for a smaller part of the US economy.
5. The US economy is now less sensitive to interest rates than in the past. One of the biggest strengths of the US is its technological innovation and high spending on research and development (R&D). It is expected that new innovations in artificial intelligence (AI) and other areas may boost US productivity bringing huge benefits to the US economy.
The above are only some of the possible reasons. There could be many more explanations, because economies are complex and harder to understand. How humans behave under certain conditions is unknown beforehand. And we're good at giving reasons after the fact.
Even after almost a century, nobody clearly knows what caused the Great Depression of the 1920s -- though many have tried to analyse its causes diligently.
The US stock market is showing signs of weakness with S&P 500 index losing almost four percent and Nasdaq Composite losing five percent in the past one week.
The US 10-year Treasury yield is now at 4.50 percent, which is almost a 16-year high. The rising yields are negatively impacting asset prices, not only in the US but also globally.
Nobody knows how long the resilience of the US economy continues, despite some pointers to a weaker economic activity in future. However, some experts say the good times may last till the end of 2023.
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Disclosure: I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.
Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets.
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He blogs at:
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