Are Fed Rates Actually Helping the US Economy?

The US Economy appears surprisingly resilient, in spite of higher borrowing costs resulting from the Federal Reserve’s (Fed) interest rate hikes. American employers added 303,000 workers in March and February’s job growth was revised up. Both months were far above economic forecasts. The unemployment rate dipped from 3.9% to 3.8%. The jobless rate has now remained below 4% for 26 straight months, the longest streak since the 1960s.  Retail sales increased 0.7% in March, more than double the consensus estimate of 0.3%. The previous month was revised up to 0.9% from 0.6%. Q1 earnings are starting to be reported and are off to a good start. All of this data taken together confirms that the economy has strong consumer demand, which partly explains the sticky, elevated, inflation.

The US Economy appears to be confusing experts who had warned of an imminent downturn because of the Federal Reserve’s interest rate hikes. What if the economy isn’t doing well in spite of higher rates but rather because of them? That idea probably seems radical in mainstream academic and economic circles, but the economic evidence is becoming hard to ignore. By several key gauges – GDP, unemployment, corporate profits - the economy now is as strong or even stronger than it was when the Federal Reserve first began raising interest rates. Why is this? We would argue that the jump in benchmark rates from 0% to over 5% is providing many Americans with a significant stream of income from their bond investments and money market / savings accounts / CD’s for the first time in two decades. The reality is that a lot of people now have more income and therefor money.  These people, and companies, are in turn spending a big enough portion of that newfound income to drive up demand and increase growth. 

In a typical rate-hiking cycle, the additional income and therefore spending from higher rates isn’t usually enough to offset the drop in demand from those who stop borrowing money because of higher interest rates. That’s what normally causes the Fed-induced slowdown. It was natural to expect this time to follow the same pattern. We feel this time could be different for a few reasons.

1. The impact of exploding US budget deficits. The government’s debt has ballooned to $35 trillion, double what it was a decade ago. That means those higher interest rates the government is now paying on the debt (the 10 year treasury yield was 0.55% in July 2020 and now sits around 4.6%) translate to an additional $50 billion or so flowing into the pockets of American (and foreign) bond investors each month.

2. US households are receiving income on more than $13 trillion of short-term interest-bearing assets like money markets, CD’s, savings accounts, etc. This is almost triple the $5 trillion in consumer debt, excluding mortgages, that they have to pay interest on. At today’s interest rates, we’ve seen estimates that say that translates to a net gain for households of approximately $400 billion a year. 

3. Many Americans managed to lock in super-low rates on their mortgages during or right after the pandemic, shielding them from a lot of the normal pain caused by rising rates. (This is a crucial difference with the rest of the world; mortgage rates rapidly adjust higher as benchmark rates rise in many developed countries.)

We also wanted to quickly address the recent stock market volatility. After two strong consecutive quarters for the market, the second quarter is off to a shaky start. Geopolitical risks are clearly a factor here. As is inflation that appears to be moving in the wrong direction. US CPI (Consumer Price Index) has now moved up on a year over year basis in January, February and March. The Fed is now expected to remain “higher for longer” which is a change from what the market was expecting in late 2023 and early 2024. At the start of the year, the bond market was pricing in 6-7 rate cuts in 2024 and now is only pricing in 2 rate cuts with the first cut not occurring until September. Based on some of the reasons outlined above, we feel that even 2 cuts this year may be overly optimistic. The uncertainty surrounding interest rates and the Geopolitical risks could continue to cause volatility. As a reminder, the average year has 3-4 pullbacks of 5% or more. A similar pullback here would be perfectly normal. The very smooth ride the market has experienced over the last 6 months is more abnormal.

Bottom Line: Higher interest rates are leading to more income for a lot of Americans and they’re spending it. Consumer spending is by far the biggest driver of the economy. Consumption accounts for roughly 70% of GDP. That’s good news for the US economy. Market volatility is normal and after a long period with relatively no volatility, a pullback is probably warranted.