United States Outlook

While inflation is higher than earnings growth, U.S. savings rates are still at 5% of disposable income, high compared to the runup to the Great Recession.

A housing market correction makes little sense right now given low inventories of existing homes for sale, just 3.3 months’ worth of supply, much lower than the 7+ months that would be considered a buyer’s market.

Even now, the ratio of money supply to nominal U.S. GDP suggests 20% to 30% more inflation over the next few years—a wide range that depends on the impact of current inflation trends on monetary velocity.

If a recession is defined as two quarters of negative growth, then the first half of 2022 was one of the oddest recessions the United States has ever seen. The data suggests that overall output in the nation fell about 0.5% in the first half of the year. Yet over the same period, the U.S. unemployment rate dropped from 3.9% to 3.5%, the nation added 3 million jobs, even as industrial production climbed to a record-high level. Indeed, if that was a recession, then long live the recession! This forecast expects that an upcoming revision to the GDP estimates may well erase the anomaly of the first two quarters of 2022 along with the debate about H1.[1] Regardless, real growth has slowed and there are signs of stress in parts of the economy such as new housing.

To understand where the United States economy is now, it is useful to make a distinction between two kinds of stresses that can occur. One form of stress is a decline in aggregate demand, which gives rise to a typical business cycle. Another form of stress comes from rapidly shifting changes in the components of aggregate demand—changes that in the aggregate are still expansionary, but nevertheless cause reduced productivity as suppliers struggle to adapt to the shifting patterns of demand. It is the latter situation that the United States is currently experiencing. This means we can have the seemingly paradoxical condition of an economy experiencing reductions in productivity even as it operates at capacity (i.e. low growth and falling unemployment).

The rapidly changing pattern of demand is being partially driven by the nation’s emergence from the historic COVID-19 pandemic. There has been an enormous shift from demand for goods back to demand for services now that the world has finally moved beyond the malady. This is much to the chagrin of Walmart and Target who appeared to be operating under the premise that people were going to continue staying home 23 hours per day judging by the excessive inventories of pajamas and kitchen appliances currently sitting in company warehouses.

But the bigger shifts in the structure of demand have been driven by the excessive stimulus the Federal government and Federal Reserve enacted in response to the pandemic—and now the backlash as they try to withdraw that stimulus to constrain the predictable side effects—namely inflation, excessive consumer demand, and bubbly financial markets. Functionally speaking policymakers went from maximum acceleration to maximum braking over a single year, something that would create turbulence in even the healthiest economy.

The U.S. Congress approved $6.1 trillion in fiscal deficit spending in 2020 and 2021, significantly more than the actual losses to the economy from the pandemic. Households, for example, received $2.60 of direct support for every $1 of lost income. This level of borrowing should have caused bond markets to swoon and interest rates to rise sharply, but the Federal Reserve swooped in with $5 trillion in quantitative easing. This paid for all the deficit spending by increasing the nation’s money supply by 35%, far and away the greatest short-run expansion of money supply ever seen in the United States.[2]

All this cash set off the explosive growth in asset prices that turned into a $30 trillion increase in U.S. household net worth, a surge of 25%. This expansion of wealth supercharged consumer demand and set off a proliferation in related investments such as home building. While tight labor markets and solid growth make good headlines, none of this is sustainable. Consumer spending now accounts for the highest share of U.S. GDP since 2006, a not insignificant comparison. The consumption binge is also apparent in the rapidly growing U.S. trade deficit, which accounts for the largest a share of GDP since the runup to the Great Recession.

Unfortunately, albeit inevitably, all this new demand has also led to price inflation; as the saying goes, it is the necessary consequence of too much money pursuing too few goods. Price growth is now at the highest pace since the 1970’s. This has forced Fed policy to pivot sharply from loosening to tightening. Within a year of ending quantitative easing, the Fed has started to sharply raise the federal funds rate. This represents a startling pace of change and one that is uncharacteristic of past Federal Reserve Boards that have typically operated much more cautiously.

Rates on the long end have been pushed by inflation, while on the short end they have been pushed by the Fed. While still low from any long run vantage point (and still negative in real terms) they nevertheless have started to put significant pressure on rate sensitive sectors such as real estate, some consumer durables, and business investment. This is what accounts for the weaker growth numbers in the first half of 2022. But to reiterate, this is not a recession, it is an economy that is modestly cooling from white-hot to red-hot.

As mentioned in this forecast, prices in the United States are rising because of intense demand from consumers driven by wealth effects. And this has not been to the detriment of demand as suggested in hyperbolic headlines such as “Consumers Crushed By Inflation.” While inflation is higher than earnings growth, consumer spending is still growing in real terms and U.S. savings rates are still at 5% of disposable income, high compared to the runup to the Great Recession. Certainly, a subset of households suffer when prices rise, particularly those on a fixed income. But in the aggregate, inflation will not really cool until real consumer demand does—and we are still far away from that happening.

Consumers will carry the U.S. economy forward for now. Firstly, there is still a lot of new wealth kicking around to keep demand strong even with recent declines in the equity markets. Secondly, earnings increases are at record high levels due to labor shortages, particularly among lower skilled workers who typically spend most of their disposable income immediately. Third, rising interest rates are simply not that central of an issue for most households now. Debt servicing levels fell to their lowest levels ever during the pandemic as consumers took advantage of ultra-low interest rates to refinance their homes. Consumers are just now turning to new debt to fund consumption. There is still a long way to go in this consumer cycle, as a look at empty auto-dealer lots demonstrate.

For all the worry about rising interest rates, the main problem is really sticker shock. Nominal rates are up, but not as much as inflation. This means that real interest rates are still negative. For example, if a lender lent you $100 today at a 5% rate, when they received $105 back at the end of the year, it would buy less in real terms since prices went up 6% over the same period. The impact of rising nominal interest rates on housing and consumer spending is really a function of having to reprice deals—real buying power has not been reduced.

One of the more ominous topics in the news lately is the sharp growth in new homes for sale (it is easy to have visions of the housing collapse that led the United States into the Great Recession). The expansion in new homes for sale has caused some economists to predict a housing ‘correction’, which can be interpreted as falling home prices. Homebuilder sentiment in the nation has collapsed.

But a correction makes little sense. First, there is a massive amount of equity in the current U.S. housing market driven by a decade of low mortgage debt accumulation. The industry is also characterized by incredibly low inventories of existing homes for sale. Inventories have risen to 3.3 months’ of supply from 2 months of supply at the end of 2021, but this is still lower than the 4 months’ of supply that were available in 2005 in the midst of the subprime bubble, and much lower than the 11 months’ of supply that was on the market after that collapse. Overall, housing vacancy rates are still at a record low level, following a decade of weak building trends. This is not a market that is due for a collapse, unlike the market in 2006—at least not yet.

The major problem for new housing is the ultra-low mortgage rates homeowners currently enjoy. Anyone who sells now will have to go from a sub-3 rate to something in the 5+ category. That is not a move most homeowners make—unless they have to. The ‘move-up’ market has been all but frozen and will continue to be so until rates begin to decline again, something that seems unlikely given the current state of inflation.

But there is ongoing and pent-up demand to enter the housing market by those ready to make the leap to ownership. Unfortunately, most first-time buyers aren’t qualified to buy a new home, and instead buy less expensive existing homes, which is difficult today given how many owners are locked to those low rates. The answer for builders is clear—it’s time to focus on new entry level housing.

The conversation about inflation today, even among economists, has been startling off track. Over the past twelve months most of the major inflation forecasts have continued to suggest that we have reached peak inflation—only to be disappointed when an even higher number comes out. These broken forecasts often list the “causes” of inflation by noting which parts of the consumption basket have experienced the greatest price increases—oil, cars, food, etc. This is completely wrong—as any economist who has studied basic monetary theory should know. As Milton Friedman famously noted, inflation is everywhere and is always a monetary phenomenon, meaning that without an increase in the money supply, price levels are functionally limited.

Take gasoline prices. While there is little doubt that the conflict in Ukraine has reduced the available supply of oil in the world, if the money supply hadn’t been expanded so dramatically the shortages would have led to just modest increases in the price of gasoline, and a corresponding decline in the consumption of it. That isn’t what happened in the United States over the last year. Gasoline prices nearly doubled from the summer of 2021 to the summer of 2022—and yet there was almost no decline in U.S. vehicle miles driven, or gasoline purchased. This clearly shows that gasoline prices went up a little because of supply constraints but went up a lot more because of the increase in demand, which in turn, was driven by the excessive stimulus.

While oil prices are moderating and the pain at the pump is finally diminishing, it does not mean inflation will end. When there is an excess supply of cash in an economy, prices must rise to absorb it. Even now, the ratio of money supply to nominal GDP suggests 20% to 30% more inflation over the next few years—a wide range that depends on the impact of current inflation trends on monetary velocity. But more inflation will have to occur unless the Fed removes the excess money from the system through quantitative tightening.

Strangely, the Fed has chosen to combat current inflation primarily through hikes in the federal funds rate, rather than through quantitative tightening. This has done only a little to help the inflation problem as it has yet to significantly reduce the money supply. Notably, the Fed’s strategy is supposed to change this month, as it starts reducing the Fed balance sheet by a moderate $100 billion per month. As this begins, this forecast anticipates that inflation will begin to slow further, but only at the cost of a sharp increase in interest rates—particularly at the longer end of the yield curve. Just how much interest rates will rise is difficult to say. The experience with the so-called ‘taper-tantrum’ a few years ago when Janet Yellen tried to reduce the Fed’s balance sheet suggests it could be severe. We simply don’t know yet.

What we do know is that increasing real interest rates will be more painful for the economy than the increases in nominal rates to date. It will cause a more substantial decline in asset prices and a drop in aggregate real demand, which may well cause the economy to contract for real. One big question is whether the Federal Reserve will be willing to stay the course, or whether they will backpedal, driven by the same populist fears that drove the overstimulation of the economy in the first place. Chairman Jerome Powel was clear in his recent speech at Jackson Hole when he said that he was serious about enduring on this course of action, but this forecast continues to have its doubts.

The Fed has managed to put itself between the rock of inflation and the hard place of asset price declines. The one bright spot in the current situation is that if the Fed does little, inflationary pressures will eventually peter out on their own. This is not like the inflation of the 1970’s when the root problem was excessive annual increases in the money supply, rather than a one-time massive increase as has happened today. However, the couple of years of high inflation that would result would cause issues for the U.S. economy. Would those issues be recession causing? It’s difficult to say. The United States experienced a great deal of inflation during the 1970’s but it took the shock of an oil crisis in the mid-70’s to create an actual recession.

Beacon Economics anticipates that the second half of 2022 will look better from a growth perspective than the first half given how fundamentals still appear strong in the private sector. Inflation will continue to run hot, and interest rates will continue to move up as a result. But this forecast does not see those circumstances as recession causing. Instead, expect a slow pace of overall economic growth, with weaker numbers from the more rate sensitive sectors.

This forecast sees two potential paths for the economy starting in 2023. The first path stems from weak Fed action, where fear of a political backlash keeps the Fed from using quantitative tightening at the necessary level. If this happens inflation will continue eating into real asset values and incomes, and generally pushing interest rates up. Any small shock could cause a recession, or it may look like 3 or more years of very weak growth, with consumers in a relatively poor financial position at the end.

The second scenario is that the Fed stamps out inflation in the near-term by aggressively reducing its balance sheet. While that would drive up interest rates in the short term, cool financial markets sharply, and possibly create a modest recession next year led by retrenching consumers, the nation would come out of it with a strong private sector.

Moreover, both these scenarios miss the elephant in the room: the Federal debt. One part of the equation that has not been dealt with is the nation’s huge Federal debt level and the rising burden of carrying such debt given rising interest rates. How long bond markets will give a blank check to the U.S. government is anyone’s guess, but at some point, bond buyers will become worried, and that is when politically tough choices about fiscal rebalancing will need to be made.

How that shakes out remains to be seen, particularly given the strained political times we live in. There will be a reckoning, but exactly when is hard to say. But when the nation’s debt does come home to roost, all of the above scenarios will be off the table and the situation will look much worse.

[1] On September 29, along with the U.S. Bureau of Economic Analysis’s third GDP release for Q2 economic activity, comes the annual update of the economic accounts. This is when new numbers for the previous one or two years are released based on better refinements of the underlying estimates of price changes and economic flows. That the BEA has been having trouble honing their models amid the current economic chaos is hardly a surprise and helps explain another mystery in the data—the exceptionally large gap between Gross Domestic Income and Gross Domestic Product—two indicators that in theory should be equal, but currently have a 4% gap. Historically this suggests an upward revision to GDP.

[2] By functionally monetizing the nation’s enormous fiscal deficit, the Fed enacted what might be the first true experiment in Modern Monetary Theory (MMT)—the expansion of the money supply to cover deficit spending. And given the path the U.S. economy is currently on it is safe to assume that the massive drawbacks of using this system to run a government have become apparent. Budgets without accountability will inevitably cause problems.