Americans Have Quietly Deleveraged. It May Explain the Economy’s Resilience.

For many, the surprise is not falling inflation, but rather the resilience of the U.S. economy. After all, peak inflation has been long predicted—if perhaps prematurely. Falling oil, food, and other commodity prices following last year’s war-related spikes have long presaged a slowing of 2023 headline inflation. More broadly, comparisons today to last year’s elevated prices were inevitably going to moderate year-on-year inflation measures. Temporary, pandemic-related shortages of computer chips, new cars, and other goods have been receding, giving way to higher production and lower prices. And, finally, observed moderation of market rental rates in the first half of 2023 will predictably feed through into diminishing shelter inflation, the chunkiest component of U.S. consumer price indices. 

U.S. headline consumer price inflation will soon dip below 3%. It is entirely feasible that core measures of inflation will fall within striking distance of the Fed’s 2% target by this time next year.

But while many economists agreed inflation would eventually be tamed, fewer thought it could be done without a recession. Aggressive Fed rate hikes, fading pandemic-related fiscal spending, and moribund growth in Europe, Japan, and China were seen by many as insurmountable headwinds for the U.S. economy. Bond markets were sending the most powerful signal of all—a deeply inverted yield curve, which is typically the single-best harbinger of a forthcoming recession.

But the latest economic figures belie U.S. recession fears. The labor market continues to create new jobs. Even at its more moderate recent pace, jobs growth is more than twice the growth of the labor supply. Consumer spending, particularly on services, is proving resilient. Even patches of earlier weakness, such as in residential housing, have exhibited renewed vigor. 

To be sure, trouble spots are also visible. Above all, commercial real estate is in a funk, a casualty of higher borrowing costs and a slow return by many workers to the office. Business investment spending is also weaker than overall final demand. Net exports are a drag on U.S. economic activity.

Still, the main story is one of resilience, particularly in the face of the largest Federal Reserve interest rate hikes in a generation (accompanied by similar moves in emerging and other developed economies).

Several factors, some of which we have written about before, help explain the economy’s refusal to roll over, among them steadfast consumer spending fueled by a stockpile of household savings hoarded during Covid lockdowns, the partial replacement of Covid fiscal stimulus with other government outlays (such as subsidies for renewable energy in the Inflation Reduction Act), and the surprising resilience of the euro zone economies to Russia’s invasion of Ukraine.

But another factor, little commented upon in much reporting about the U.S. economy, may also be at work. Specifically, owing to changes in household and corporate borrowing since the global financial crisis of 2008, U.S. private sector spending may be less interest-rate-sensitive than is commonly believed. If so, the Fed’s rate increases may not be sapping as much demand from the economy as would have been seen in the past.

Since the global financial crisis, U.S. households and creditors have made significant changes in their attitudes toward borrowing and lending.

For instance, from the end of 2007 (the eve of the global financial crisis) to the end of last year, the stock of U.S. household debt, as a percentage of U.S. gross domestic product, has fallen by a quarter, from 101% to 77% of GDP. Notably, that decline in household indebtedness has occurred despite a prolonged period of very low interest rates, the opposite of what might have been expected.

Partly, that was an understandable response of U.S. households to the massive dislocations in housing, labor, and financial markets during the financial crisis and the ensuing recession. But lending decisions have also been important. Banks and other mortgage lenders tightened credit standards, for example, all-but removing “subprime” from the home-lending lexicon. Adjustable-rate and interest-only mortgages all but disappeared, with borrowers reverting to longer-term fixed rate forms of housing finance. The home-equity loan market scaled back as well.

In short, prudence and restraint—by borrowers and lenders alike—have reduced the stock of household debt to income and have led to a greater use of longer-dated, fixed rate borrowings. As a result, today housing debt is less sensitive to interest rate fluctuations than it was prior to the financial crisis.

The past 15 years have also witnessed a decline in the amount of money Americans must set aside to service their debt. The household debt servicing ratio has fallen steadily from 13.2% of disposable income in 2007 to 9.6% at the end of the first quarter of 2023. While falling interest rates have been important to that outcome, they only account for part of the decline in debt-servicing costs. To wit, as the Fed raised rates by five percentage points over the past 18 months, household debt-servicing costs only rose by 1.5 percentage points of disposable income. That is considerably less than would have been the case if the total stock of debt were at pre-2008 levels and if the fraction of adjustable-rate borrowings had not fallen sharply oversince.

For business, similar if more modest dynamics are also apparent. Prior to the financial crisis, total U.S. corporate debt securities and loans, as a share of GDP, peaked at 45%. Today that figure is 43%. Corporate debt as a share of corporate net worth is now at 50-year lows. That is the opposite of what one might expect, given the super-low interest rate era from 2010 to 2022 and the simultaneous robust expansion of credit opportunities offered by corporate-bond and private-credit markets over those years. On average, the data suggest that corporate borrowing has been restrained, not excessive, in recent years. 

Since 2008, the average maturity of business credit outstanding has also lengthened. That partly reflects the demise of short-term commercial paper markets during the financial crisis, with a substitution toward greater reliance on longer-term bond issuance. That was a logical corporate finance response to the significant rollover and liquidity risks companies had faced then. 

Altogether, debt servicing costs for the corporate sector will probably rise over time owing to higher interest rates, but the lags between higher rates and the squeeze on corporate cash flows is probably longer than in prior cycles. 

The largest increase in indebtedness over the past fifteen years resides in the public sector. The ratio of U.S. government debt to GDP has roughly doubled from 64% in 2007 to 120% at the end of 2022.  

But unlike the household and corporate sectors, the U.S. federal government is not cash-constrained. High levels of indebtedness and even rising debt servicing costs, alone, are unlikely to either precipitate a credit crunch by lenders or a rapid policy shift to reduce government deficits and debts.

The evidence for the former is in plain sight. While the Federal Reserve has raised short rates 500 basis points in the past 18 months, longer-term borrowing rates have risen by only 350 basis points, even as the Fed has announced and initiated a reduction of its balance sheet holdings of Treasuries. (A basis point is one-hundredth of a percent.) Private sector demand for U.S. debt securities remains robust and unlikely to change, despite rising government indebtedness and debt servicing costs.

As for policy, divided government in a polarized political environment all-but assures the continuation of the status quo, with no major policy legislation passing Congress and becoming signed into law. Accordingly, a sudden or sharp fiscal consolidation appears highly unlikely until after the 2024 elections, at the earliest.

So, is a soft-landing assured? 

No, stuff can still happen. But the risks of a harder landing precipitated by aggressive Fed tightening are receding. Mainly, that is because inflation is finally behaving as most economists thought it would. But a contributing factor is a U.S. economy that is more resilient to higher interest rates than many thought possible.

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