Consumer Credit Rises Despite Higher Interest Rates, Keeping A Recession At Bay

The Federal Reserve has been raising its short-term interest rate to reduce inflation. The idea is that higher rates will reduce demand for borrowing (i.e. credit), which will slow down the economy. Has the Fed been successful? Is the economy slowing? Will the U.S. enter a recession soon? Will the Fed continue to hike or cut interest rates?

Recent Fed Rate Hikes

After leaving its short-term rate at zero for well over a decade, the Fed has hiked rates 10 times since March 2022 (see chart below). The idea is that higher rates will reduce demand for loans and slow economic growth. Has it succeeded? To some extent, yes. Inflation has fallen from its peak of 9.1% (y/y) to 4.9%. Regardless of higher rates, consumers continue to borrow.

Consumer Debt Continues to Rise

Despite the efforts of the Federal Reserve, consumer debt continued to increase a full year after rate hikes began. The table below contains the data for the first quarter of 2023. Mortgage debt, which is the largest component of total consumer debt (71%), increased by $121 billion. Student loan debt, which comprises 9% of total consumer debt, increased $9 billion during the quarter. Following a 13-year declining trend, HELOC debt rose for the fourth consecutive quarter, increasing by $3 billion. Auto loans rose by $10 billion during the quarter, continuing an upward trend that has been in place since 2011. Finally, credit card debt was flat during the quarter. In total, consumer debt rose from $16.90 trillion in the fourth quarter of 2022 to $17.05 trillion in the first quarter of 2023.

For an historical view of the various types and amounts of consumer debt since 2003, please refer to the following chart.

Is the Economy Slowing?

This is a particularly difficult question to answer since the U.S. economy is so massive and diverse. In other words, some statistics suggest it is slowing while others seem to dispute this notion. For example, when looking at the 12-month period ending March 31, 2023, housing starts fell 17.25%, which indicates new residential construction has slowed. Despite this, GDP rose almost 7.0% during the same period. Retail sales had a modest increase during the most recent 12-month period. With this level of economic uncertainty, will the Fed continue to raise interest rates?

Will the Fed Continue to Raise Rates?

The Federal Reserve has hiked interest rates by 5.0% in the past 14-months. It should be noted that it takes approximately 12 months to see the full effect of a rate hike. Has the Fed gone too far? Will it continue to raise rates? Some even suggest the Fed will cut rates later this year. A rate cut this year is likely wishful thinking. It’s more likely that the Fed will raise another 0.25% at its next meeting in June. Why? Because the economy is still going strong, and the Fed needs to slow demand to bring inflation down to its 2.0% target.

Is a Recession Looming?

A recession seems unavoidable to this author. Historically, the Fed has been a primary catalyst in causing recessions by raising too far or keeping rates high for too long. It’s possible that the supply chain constraints from the pandemic are normalizing, which may be a big reason inflation has fallen to its current level. As the current round of rate hikes filters through the system, credit will slow along with the economy, making a recession more likely. However, if consumers continue to borrow, it may be a while before the economy contracts and a recession emerges. Moreover, if wages continue to rise, the consumer may continue to spend, keeping the economy strong for a bit longer.

Stay tuned for more information.