How do a tight interest rate regime and a stable economy fit together? A glance into the past reveals that the delayed impact of interest rate hikes on the economy is rather a rule than an unusual occurrence.
In the past 20 months, we witnessed the largest and sharpest increase in interest rates since the start of the "Great Moderation" in the mid-1980s. Despite high interest rate levels similar to those prefacing the "Great Financial Crisis", the US economy is solid as a rock and recently released quarterly GDP results that remind us more of an economic boom than a recession. We ask, how do a tight interest rate regime and a stable economy fit together? In our view, the past and recent economic data paired with historical insights help investors to understand the situation.
A major reason for the stability of the US economy despite high interest rates is strong and sustained fiscal support. The massive fiscal packages aimed at alleviating the impact of the pandemic lasted well into 2022, and their repercussions are still at work. Moreover, the US launched large government spending programs in the past two years, such as the "Inflation Reduction Act" and the "CHIPS and Science Act". The elevated government spending of the recent years fueled investment and job growth, which - among other reasons - lead to the lowest unemployment rate in the US seen in the past 50 years. In combination with positive real wage growth despite high inflation, the strong labour market offers some buffer helping the economy to withstand higher interest rates for now.
If employment is high and real wages grow, households increase their consumption and lift economic growth. After all, private consumption is the most important factor for the US economy, accounting for roughly two thirds of its GDP. Moreover, household savings exploded during the pandemic and served as cushioning for personal income losses since. In addition, the repayment of student loans, which totals to roughly USD 1.6 trillion, was set out until the end of September 2023. Together, the aforementioned factors offer comfortable buffers against the adverse effects of high interest rates.
Despite the strong fundamentals, we start seeing the first small cracks in the US economy. Several fiscal packages are running out and government spending is expected to slow down as the federal budget is likely tightened in the next negotiation round in mid-November. Moreover, the unemployment rate increased slightly in the past months, the repayment of student loans restarted, the savings rate decreased - which equals a depletion of disposable income - and delinquency rates on consumer loans began to increase. As the economic buffers get thinner, the adverse effects of monetary tightening are beginning to unfold and weigh on consumption, investment and government expenditure. The weak US economic indicators published last week suggest that this phase has finally begun. After all, it seems the negative effects of high interest rates have started to kick in and we can expect lower US GDP growth in the quarters to come.
A glance into the past reveals that the delayed impact of interest rate hikes on the economy is rather a rule than an unusual occurrence. Between the peak plateau of the Federal Funds Rate and the peak plateau of the unemployment rate lie historically between six and twelve quarters. This suggests the worst in terms of economic slowdown is still to come. However, given the strong fundamentals, the worst might actually not be too bad this time.