Economy soars over summer 

October 26, 2023

Real GDP rose at a 4.9% annualized pace over the summer, more than double the 2.1% pace of the second quarter and the fastest pace since late 2021. That was despite the most aggressive credit tightening by the Federal Reserve since the 1980s. How can that be? 

Households and firms used the stimulus provided during the first two years of the pandemic to further shore up their balance sheets. They locked into ultralow rates when they could, paid down existing debt and banked the excess savings they amassed during initial lockdowns. Recent revisions revealed that households alone still had $1.4 trillion in excess savings as of August, nearly double previous estimates. Those shifts and the fact that the households and firms are experiencing a surge in interest earnings on that cash blunted the blow of higher rates. The cooling of inflation in and of itself was a plus as it alleviated the loss of purchasing power lost to inflation earlier in the cycle.  

Nearly every sector of the economy posted gains during the quarter, except for nonresidential investment. Consumer spending accelerated as consumers snapped up everything from big-ticket items to concert tickets. Vehicles that were finally restocked were snapped up after delays due to chip shortages and supply chain disruptions earlier in the cycle. Spending on healthcare also accelerated as backlogs at doctors’ offices continued to grow. 

Housing added to growth for the first time in nine quarters over the summer. Builders cut back on the size of homes that they built and offered sales incentives including temporary mortgage buydowns to buoy first-time buyer demand, even as rates surged. Those gains will be short-lived since the surge in Treasury bond yields pushed mortgage rates to their highest level this century since September. Many builders complained that foot traffic disappeared in October and turned their developments into ghost towns as rates continued to spiral. Existing home sales plummeted to their lowest level in 13 years in September, while mortgage applications – a sign of future sales - dropped to their lowest level since the mid-1990s in recent weeks. 

Business investment was the outlier, moving essentially sideways after posting robust gains in the second quarter. Ongoing gains in construction activity for computer chip plants and intellectual property didn’t quite offset a drop in spending on new equipment. Incentives to build chip plants have fueled a tripling of chip plant construction from a year ago. Even inventories, which are much more expensive for companies to hold, given the rise in rates and insurance costs, were built during the quarter. Companies were replenishing inventories on the heels of robust consumer spending.

Government spending accelerated at its fastest pace since the fourth quarter of 2022. A surge in defense outlays buoyed federal spending, while the ramping up of earlier infrastructure spending boosted growth at the state and local levels. State and local governments are still scrambling to fill positions left vacant after the economy reopened. Teachers and support staff remain scarce in public schools. Young teachers opted out of the profession as their prospects improved elsewhere when the economy reopened.  

Finally, the trade deficit narrowed, with exports rebounding more rapidly than imports over the summer. That improvement is expected to be reversed in the fourth quarter. Growth abroad is weakening, while a strong dollar is reducing our competitiveness abroad and reducing the cost of imports.   

The resilience of the economy is both a blessing and a curse for the Federal Reserve. It ups the odds of the once elusive soft landing, while raising the risk of reigniting the cooling embers of inflation. Stronger growth also justifies higher rates, which is one of the many reasons Treasury bond yields have risen in recent months. The movement in the Treasury bond market represents a much broader tightening of credit conditions; it has already derailed the momentary strength in housing this summer. Mortgage applications have plummeted to multi-decade lows in recent weeks. That is something the Fed will take into account as it deliberates on policy next week. 

We are expecting another hawkish hold by the Fed at the conclusion of the November 1 meeting.  The Fed will keep options for a rate hike on the table, as it weighs how much the recent rout in the bond market will do the heavy lifting on rate hikes.