Fed Pauses, Eyeing to Engineer an Economic Soft Landing
But we believe mounting pressures on consumers, who account for 70% of U.S. economic output, suggest a recession is likely on the horizon.
Seeking to tame inflation without eliminating growth, the Fed held interest rates steady for the second time in its current campaign.
Given the mounting pressure on consumers from high interest rates and elevated inflation, additional rate hikes likely will be unnecessary.
High lending rates, depleted savings accounts and the resumption of student loan payments are further squeezing consumers and fueling recession risk.
Citing progress — but not yet victory — in controlling inflation, the Federal Reserve (Fed) paused its rate-hike campaign on Wednesday. The pause marks the Fed’s second break since June and follows a quarter-point rate increase at its last policy meeting in July. The short-term lending target remains at a range of 5.25%-5.5%, a 22-year high.
Soft Landings Are Hard to Achieve
With its recent pause-hike-pause strategy, the Fed hopes to orchestrate a soft landing to avoid tipping the U.S. into recession. Taking another break allows the economy to absorb the full force of the 18-month monetary policy operation. As we’ve noted previously, rate hikes can take up to two years to have the Fed’s desired effect on economic activity.
However, history demonstrates that economic soft landings have been rare.1 Since 1960, the Fed has launched 12 tightening cycles, only four of which ended in soft landings: 1960-1966, 1982-1984, 1994-1995 and 2015-2018. We see three common themes in the soft-landing cycles (and none characterize the current cycle):
No inflation spike.
A modest pace of Fed tightening.
An easing of bank lending standards.
We believe that achieving a soft landing is a long shot in today’s environment of still-elevated inflation and multiyear-high interest rates.
Inflation, Fed’s Response Weigh on Consumers
The gradual slowdown in the monthly year-over-year Consumer Price Index (CPI) suggests that the Fed’s rate hikes are helping to corral inflation. However, the cumulative effect of more than two years of rising/elevated inflation has taken a toll. From January 2021 through August 2023, consumer prices were up 17.4% on average, according to the CPI.
At the same time, the Fed’s inflation-fighting strategy has pushed auto, mortgage, credit card and other consumer loan rates to multiyear highs. Rising prices and higher lending rates have drained savings accounts and pushed mortgages and other loans beyond reach for many people.
These factors may explain sinking consumer confidence readings. A Conference Board measure of consumer expectations over the next six months dropped to 80.2 in August from 88 in July. A reading of 80 historically has signaled a recession within the following year.
Consumers Will Likely Cut Back on Nonessential Spending
The economy owes much of its recent strength to robust consumer spending. But certain factors that financed and supported that spending are in jeopardy:
Excess savings. Savings accumulated during the pandemic helped fuel post-pandemic consumer spending gains. But, according to the Fed, consumers finally depleted their excess savings in the first quarter of this year.2 Even more concerning, a Fed survey released in May showed that 37% of Americans lack enough money to cover a $400 emergency expense, up from 32% in 2021. And a record 35% said they were worse off financially than the previous year.3
Living standards. Amid high inflation, Americans’ living standards have declined. Inflation-adjusted median household income fell 2.3% to $74,580 last year from $76,330 in 2021, according to the U.S. Census Bureau. Since peaking in 2019, median household income has dropped 4.5%.4
Student loan payments. For the 27 million consumers with federal student loans totaling $1.1 trillion, it’s time to pay up again after a 3.5-year moratorium on loan payments.5 Launched in March 2020, the freeze boosted discretionary spending for millions of borrowers, as Figure 1 demonstrates. Payments resume on October 1, which the Wall Street Journal claims could divert up to $100 billion in consumer spending over the next year.6
Figure 1 | Student Loan Holders Are Boosting Their Debt Loads
% of Borrowers Taking on New Products
Unsecured personal loans
Source: TransUnion U.S. consumer credit database as of 5/31/2023. Products opened on or after 3/31/2020.
Soaring Mortgage Rates Make It Difficult for People to Afford Homes
Coinciding with the Fed’s rate hikes, mortgage rates recently climbed to their highest levels in over 20 years. At the same time, the dwindling supply of homes has kept prices unusually high. These factors, combined with median income data, mean U.S. housing market affordability is lower than at the peak of the housing bubble in 2006.7
Furthermore, average home payments have doubled since the pandemic. Assuming a 30-year fixed-rate mortgage of 7.37% and a 20% down payment, the monthly payment for a buyer purchasing an average U.S. home was $2,430 in July 2023. In summer 2019, the average payment was less than $1,200.8
Mortgages aren’t the only consumer loans saddled with rising interest rates. Four-year auto loan rates climbed to 7.6% in May, compared with 5.2% a year earlier, according to the Federal Reserve Bank of St. Louis.
Tougher Lending Rules Lead to Fewer Loan Requests and More Denials
Following the collapse of several regional banks earlier this year, many lenders quickly tightened their loan standards. And they expect to maintain these restrictions through year-end.
The Fed’s latest Senior Loan Officer Opinion Survey (SLOOS) reported many banks raised their standards for mortgage and car loans and credit cards. At the same time, banks reported falling demand for all types of loans except credit cards.
Meanwhile, the overall credit rejection rate surged to 22% in June, the highest level in five years. Rejection rates for auto loans, mortgages and credit card limit increases rose to new highs.9
Job Market Strength Persists, but Layoffs Remain a Wildcard
In addition to elevated inflation, a stronger-than-expected labor market also has fueled the Fed’s hawkishness. While the overall unemployment rate has inched higher recently, it remained a relatively low 3.8% in August.
Nevertheless, certain trends suggest that the labor market may be cooling.
For example, through the first seven months of 2023, companies announced nearly 482,000 job cuts, with more than one-third of them in the technology sector. Meanwhile, there were only 159,000 job cuts during the same period of 2022.10
Elsewhere, the latest Job Openings and Labor Turnover Survey (JOLTS) reported that job openings in July dropped to their lowest level in nearly 2.5 years. The JOLTS also showed that the number of people quitting their jobs fell to early 2021 levels, suggesting waning confidence in the labor market.
Additionally, profit margins for the S&P 500® Index were 11.6% in the second quarter, compared with 12.2% a year earlier, according to FactSet. Looking ahead, we believe pressures on profit margins will build as consumer spending cools, which could lead to more layoffs.
Recession Stays on the Radar
As still-elevated inflation and high interest rates continue to weave through the economy, we expect further pullbacks in consumer spending. In addition, the resumption of student loan payments and consumers’ fading savings likely will dampen discretionary spending.
The Fed remains reluctant to end its rate-hike campaign officially and believes a soft landing is possible. History and the mounting strains facing consumers convince us that such a rosy scenario is unlikely. Given that consumers drive most of the nation’s gross domestic product, we believe recession risk remains heightened and a downturn is the most likely outcome.
Staying Focused on Potential Opportunities
In periods of heightened market and economic uncertainty, we encourage you to remain disciplined and focused on your long-term investment plan. Investing across multiple asset classes with professional investors skilled in risk management may be prudent in the current market climate.
Our investment teams have been anticipating an economic slowdown and positioning our portfolios accordingly. Given our outlook for recession, we believe emphasizing higher-quality equity and fixed-income securities remains warranted.
It’s also important to remember that attractive investment opportunities often emerge during market unrest. We suggest investing with experienced professionals with the insights and discipline to recognize and potentially capitalize on such prospects.
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Francois de Soyres, Dylan Moore and Julio Ortiz, “Accumulated Savings During the Pandemic: An International Comparison with Historical Perspective,” FEDS Notes, Board of Governors of the Federal Reserve System, June 23, 2023.
Board of Governors of the Federal Reserve System, “Economic Well-Being of U.S. Households in 2022,” May 22, 2023.
U.S. Census Bureau, “Income, Poverty and Health Insurance Coverage in the United States: 2022, News Release, September 12, 2023.
TransUnion, “With 27 Million Set to Resume Payments, Many Student Loan Borrowers Already Managing Increased Debt Since Pre-pandemic,” July 19, 2023.
Gabriel T. Rubin and Joe Pinkser, “Student-Loan Restart Threatens to Pull $100 Billion Out of Consumers’ Pockets,” Wall Street Journal, September 16, 2023.
Federal Reserve Bank of Atlanta, Home Ownership Affordability Monitor, data updated August 16, 2023.
Evan Wyloge, “The Monthly Payment for a Starter Home is How Much?! See America’s Home Affordability Crisis, Metro by Metro,” Realtor.com, August 22, 2023.
Federal Reserve Bank of New York, “At a Glance: Findings from the June SCE Credit Access Survey,” accessed September 18, 2023.
Safiyah Riddle, “U.S. layoffs fall to lowest level in nearly a year,” Reuters, August 3, 2023.
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