Retail therapy…The outlook for the U.S. consumer

November 8, 2023

The economy surged at a 4.9% annualized pace over the summer, its fastest since 2021. Gains in consumer spending alone accounted for more than half of that increase. Spending on everything from vehicles, which require financing, to clothing and concert tickets accelerated. Taylor Swift and Beyoncé single-handedly lifted the economic fortunes of the cities they toured.

More stunning is that those spending gains occurred in the wake of the Federal Reserve’s most aggressive credit tightening cycle since the 1980s. The U.S. was an outlier among its peers. Growth in Europe slowed with many economies slipping into or flirting with recession.

Our elected officials decided that COVID would not be the iceberg that took down the ship. Fiscal and monetary stimulus gave households lifeboats with supplies to traverse COVID-tainted waters. We can debate whether that stimulus overshot, given the flare in inflation. What is not debatable is that it worked.

Households paid down debt, locked into low mortgage rates and banked the savings. The once beleaguered U.S. consumer emerged an Atlas, holding up the global economy.

Inflation has cooled but the Fed refuses to declare an end to higher rates. “The historical record cautions strongly against prematurely loosening policy. We will stay the course until the job is done,” said Chairman Jay Powell.

This edition of Economic Compass takes a closer look at household balance sheets and what it will take to slow consumer spending. Powell expects a period of “below-trend growth.” That is fedspeak for a rise in unemployment. Can we have a rise in unemployment without slipping into a  recession? We already have. Unemployment moved from 3.4% in April to 3.9% in October, despite a surge in growth. How? Productivity growth picked up, which enabled firms to do more with fewer hires.

Special attention will be placed on the Fed’s game plan. It is waiting to see how earlier rate hikes and the rout in the Treasury bond market play out.

Chart 1 compares the recent performance of consumer spending against our forecast through 2024. Consumer spending is poised well at the start of the fourth quarter, given the persistence of strong gains through September. Consumers do not need to do much from here to get another solid quarter of gains.

Prospects for the start of the year are worse. Spending related to housing and big-ticket items, which need to be financed, is the most vulnerable. Spending on services is expected to weather the transition better. Taylor Swift concerts a year from now are sold out; good tickets are selling for over $3000 apiece.

Tailwinds

Consumers entered the summer with a host of tailwinds, many of which persist today:

• Inflation cooled more rapidly than compensation, which restored some of the purchasing power lost to inflation. (See Chart 2.)
• Households still had $1.3 trillion of the $2.3 trillion in excess savings amassed during the pandemic, nearly double previous estimates. Baby boomers are spending much more after they retire than earlier cohorts, supported by the interest they are earning on those deposits.
• Debt service burdens remain low, which is enabling consumers to take on more debt. (See Chart 3.)
• Household net worth jumped at the fastest pace and to the highest level on record between 2019 and 2022. Gains spanned income strata, age and educational attainment.

Households were in such good shape that student loan borrowers started to repay their debts in August, two months ahead of the end to COVID-era forbearance. Those who could, got ahead of the interest that was about to accrue on that debt.

Even the housing market, which had been frozen in the grip of what has become known as a mortgage winter, showed signs of thawing. Homeowners who are locked into low rates can’t afford to trade up, while more than 40% of homeowners have paid off their mortgages. Builders built smaller, more affordable homes and offered deep discounts to keep first-time buyers in the market.

Few opted into adjustable rate mortgages. That is a legacy of the subprime crisis. Many are unaware of how adjustable rate mortgages work after such a long period of low fixed rate mortgages, while others fear the uncertainty of adjustable rate mortgages - rates can go up and down.

Job openings remained elevated at the end of September but the response rate to the surveys has deteriorated. Data by the job posting sites suggest that job openings and advertisements for wages have cooled more rapidly than in the “official” government data but remain well above pre-pandemic levels.

High-propensity business formation – businesses with the intent to hire – picked up in September and is nearly 60% above pre-pandemic levels. The return of dynamism in the U.S. economy has been a welcome shift and added buoyancy to the labor market. However, the failure rate on new businesses is high, especially in an environment where credit is tighter.

Chart 8 shows the trajectory for the core (excluding food and energy) personal consumption expenditures (PCE) index, the Fed’s favored measure of inflation. Recent data suggest underlying inflation may be getting stickier. The persistence of inflation, particularly in the service sector, is worrisome. Medical insurance costs are scheduled to rise rapidly as plans are renewed, while deductibles are rising.

The Fed wants to see core PCE drop below 3% for an extended period before it starts normalizing policy. That puts the first rate cut in June. That is a bit sooner than we expected last month, but is contingent on higher Treasury bond yields. The descent in rates is expected to be slower than the ascent.