The Strategist

Why the US economy is still thriving despite higher interest rates

Last year, many experts predicted a recession for the US economy due to a rapid increase in the key interest rate from zero to 5%. This hike was expected to slow down investments and demand, pushing GDP growth into negative territory. Surprisingly, the economy has continued to grow and the odds of a recession remain low. This can be attributed to three main factors: structural changes, private sector resilience, and fiscal spending.

Tina Jessop, Senior Economist, LGT Private Banking
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10 minutes
Strategist US economic resilience
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Structural changes reduce rates sensitivity and cyclicality

Investments have shifted significantly from physical assets such as structures and equipment to software, driven by the transition to a digital economy. Today, a third of corporate investment goes into software, which is less sensitive to interest rates and economic cycles than traditional investments. These software investments are often long-term and less likely to be debt-financed, reducing their interest rate sensitivity.

Labour markets have also evolved, with employment increasingly shifting to the service sector, which is less vulnerable to economic downturns compared to the goods-producing sector. The service sector now accounts for 85% of non-farm payrolls, compared to 60% in the 1960s, making the labour market more stable. 

Private sector resilience through liability management and asset price gains

The private sector's ability to manage liabilities and assets has also played a crucial role in sustaining economic growth. Many companies and households locked in low interest rates before the Federal Reserve started raising rates. Companies issued fixed-rate bonds or hedged the interest rate exposure on loans, while households secured long-term fixed-rate mortgages. In addition, rising asset prices and strategic cash management have increased net worth and interest income, reducing the impact of higher interest rates from the liability side for the private sector. Consumer spending has remained strong, supported by savings from the pandemic and asset price gains. This is particularly true for higher income households (the top 60%), who drive 80% of spending.

Substantial fiscal spending boost

Government spending has provided additional support to the economy, as evidenced by unusually high US budget deficits. Large-scale fiscal policies, such as the CHIPS Act and the Inflation Reduction Act, have stimulated investment and demand, for example in manufacturing construction, offsetting declines in other areas like residential construction. 

Tighter monetary policy is still being felt

While overall economic activity remains strong at the aggregate level, certain sectors are feeling the pressure of high interest rates. Residential construction has slowed. Higher borrowing costs are affecting lower-income households and smaller companies. Lower-income households, for example, usually do not own homes or financial assets, and are more reliant on consumer credit for everyday living.

The longer rates stay high, the larger the impact on growth

In sum, the US economy's unexpected resilience can be credited to structural shifts in investments and labour markets, private sector resilience, and significant fiscal spending. While there are signs of economic cooling, these factors have so far kept growth near, or even above, trend levels. However, the prolonged effect of high interest rates should eventually slow down real GDP growth. If high interest rates persist, their negative impact on GDP growth is expected to become more pronounced over time.

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