The Confusingly Strong Economy Told in Three Stories
The plausible explanations for the economy’s apparent immunity to high interest rates each lead to different outcomes for the markets
WSJ
Why America’s economy proved surprisingly resilient to the biggest rise in interest rates in 40 years isn’t a question of merely historical interest. Depending on the explanation you prefer for the unusual strength, you should be piling into stocks, worrying about government debt or fearing recession.
Uncertainty about which of the three is right helps to explain why no one—including the Federal Reserve—seems to be able to settle on a single story about what’s going on.
I see three plausible explanations for the economy’s apparent immunity to high interest rates:
Private-sector productivity, measured as output per hour, has been rising strongly since the first quarter of 2022 when the Fed belatedly started to increase interest rates. At the end of last year, it passed its pandemic peak, which anyway was a figment of statistics due to the distortions of the lockdown economy.
The bullish story is that productivity has been boosted by workers moving en masse to better-paid and more productive jobs. Rather than flipping burgers, recent graduates have been in demand as the economy runs hot and unemployment stays near half-century lows.
Corporate investment has also rebounded much faster than it did after the 2007-2009 recession, now 10% higher than its prepandemic peak even when adjusted for inflation, against just 5% by the end of 2012, the same length of time from the 2009 low. The benefits of artificial intelligence, if they come through, might allow productivity to keep rising.
The bearish story is that productivity only rose because supply chains snarled by the pandemic were finally freed up, and that isn’t going to happen again.
The gains in productivity that have come through have allowed the economy to grow even as inflation comes down. If technology allows productivity to keep rising fast, the economy should be better able to resist higher interest rates—and stocks do well in the future even as the Fed keeps rates high.
The government financed everything, so of course it has been fine (sell Treasurys!)
Fiscal spending is also a good explanation for what happened. The Federal government ran a record peacetime deficit during the pandemic, and last year increased its deficit to 6.2% of GDP even as the economy grew strongly. Combine subsidies for anything with a hint of green with leftover stimulus savings and it is easy to see how the economy could resist higher interest rates.
Unfortunately, this can’t end well: Either the government will rein in spending, removing support and so most likely slowing growth, or it won’t, and higher borrowing will keep pushing up bond yields. Both are worth worrying about.
Monetary policy is taking longer than normal to bite (eventually it will, threatening growth)
The ineffectiveness of rate increases so far is obvious. Far from reducing demand, the economy grew faster as rates rose further. Much of that was just luck. But the risk is that the impact of rates on the economy hasn’t been abolished, merely delayed.
With hindsight, it is easy to see why higher rates didn’t immediately reduce corporate investment or household consumption. Big companies and homeowners had locked in record amounts of debt at record-low rates. Instead of Fed tightening hurting their income, major corporations and people with a mortgage kept paying the same rate but earned more in interest on their savings.
American nonfinancial companies are estimated by the Bureau of Economic Analysis to be paying about 40% less in interest, net of interest on savings, than they were before the Fed’s rate rises started. This shouldn’t be taken too literally, since recent data are calculated as the leftovers after adding up government, consumer and foreign interest, not measured directly. Still, assuming the direction of the data is right, it is the precise opposite of what the Fed’s been trying to achieve.
The U.S. economy gained strength during the year, as Americans continued to spend money, giving the economy an unexpected boost. WSJ’s Dion Rabouin digs into the latest GDP report to explain the most important details for investors in 2024. Photo: Frederic J. Brown/AFP/Getty Images
Not everyone in the U.S. benefited. The U.S. has a two-speed economy, something I’ll come back to in future columns. Small companies and those with poor credit ratings tend to have shorter-dated debt that needs to be refinanced at higher rates or have floating-rate debt. Individuals who borrowed on credit cards or to buy high-price secondhand cars are struggling, with delinquency rates now above prepandemic levels—and the young and poor have the biggest problems, according to the New York Fed.
As time passes and rates stay high, more and more debt needs to be refinanced. More borrowers who put off moving to avoid having to take a new mortgage at much higher rates will bite the bullet. More companies have to repay their bonds. And more economic activity that would have been financed by debt at lower rates just doesn’t happen.
For now, investors aren’t concerned that a delayed impact of higher rates will turn the two-speed economy into an overall slowdown. Even the worst-rated CCC junk-bond borrowers only yield about the same—13.5%—as they did in December 2019. Interest rates are higher, but offset by investors demanding a lower spread over safe Treasurys to compensate for extra risk.
SHARE YOUR THOUGHTS
What is your explanation for the health of the American economy despite high interest rates? Join the conversation below.
The danger is that the mess in the slow-speed part of the economy drags down the rest. This could be transmitted via trouble in highly-leveraged private equity, commercial real estate or lenders such as regional banks particularly exposed to weaker borrowers. But it seems more likely just to be a slow burn as delinquencies and defaults steadily rise.
The problem for investors is that all three explanations of recent history are attractive and lead to completely different predictions if they continue to hold: Solid growth, government debt bomb or hard landing.
In the past few months, the markets have swung from one extreme to the other, and back again. Expect that to continue. Nobody can get their story straight.
