Growth at Greater Risks From Supply Shocks Than Tighter Financial Conditions

Summary

• Net Fed tightening has not changed financial conditions much and growth remains well above trend.
• Strong consumption largely reflects the impact of the 2022-24 immigration surge and government-funded household deleveraging during the pandemic.
• Strong corporate investment reflects strong cash flow rather than increased leverage.
• The above suggests growth is more at risk from negative supply shocks and high policy uncertainty than from tighter financial conditions.

Market Implications

• I still expect no cuts in 2025 against markets pricing of about 2.3 cuts.

Limited Fed Impact on Financial Conditions

Even though the Federal Funds Rate (FFR) is 410bp higher than when the Fed started tightening in March 2022, financial conditions are roughly unchanged and growth has accelerated to about 3%, well above trend of about 2% (Charts 1 and 2). Here, I discuss the disconnect between financial conditions and growth.

Consumption Growth Decoupled From Financial Conditions

The main impact of financial conditions on growth is through wealth effects and funding availability and cost. Regarding the household sector, wealth has increased markedly relative to pre-pandemic, largely due to higher equity and home prices (Chart 3).

Yet by contrast with, for instance, the early 2000s, consumption has not increased relative to income. This disconnect could reflect wealth becoming less liquid (share of cash in total assets has gone back to pre-pandemic levels, Chart 4). Also, while higher home prices have been an important driver of the wealth increase, by contrast with the early 2000s, households have not monetized them. HELOC credit growth has been limited.

While household wealth has risen sharply despite Fed tightening, household borrowing has fallen sharply (Chart 5). This could reflect that households borrow mainly from banks and that banks initially tightened credit standards in response to Fed tightening.

With Fed easing banks have been loosening standards and household credit has started to stabilize but remains well below historical norm. By contrast, consumption growth has been the key driver of the GDP growth acceleration (Chart 2).

Two broad reasons explain the credit-consumption disconnect. First, a surge in immigration during 2022-24, which the Congressional Budget Office estimates around 3mn a year, against about one million pre-pandemic. Comparing total consumption with consumption per capita shows the immigration impact (Chart 6; I have used nonfarm payrolls as a proxy for population due to the Census Bureau underestimating the latter). Consumption per capita fell after the 2021 splurge as consumers digested their large purchases, especially of durable goods. Total consumption kept increasing only because of the larger number of consumers.

Second, households’ debt service ratio remains about half a ppt of income below pre-pandemic, despite the increase in the FFR (Chart 7). This reflects two factors: most US mortgages are on fixed interest rates and households have not added to mortgage borrowing. In addition, households used the government cash handouts, rather than borrowing, to pay for the 2021 consumption splurge. Since the government borrowed to fund the handouts, an increase in government debt has effectively matched the decline in household debt (Chart 8).

Cash Flow Driven Corporate Investment

Corporate borrowing has also been below historical norms (Chart 9). While corporate (mainly non-residential) investment is slowing, this likely reflects strong investment over recent years. Relative to GDP, non-residential investment remains near the historical high (Chart 10). Businesses seem to be relying less on credit to fund investment, which could reflect historically high profits (Chart 11 and 12).

Growth Risks More From Supply Side Than Tighter Financial Conditions

The above analysis suggests a limited tightening of financial conditions may have little impact on growth. By contrast, growth could be more exposed to the Trump administration’s policies, such as large deportations of illegal migrants, tariff increases, and an uncertain business environment.

Large deportations could negatively impact economic demand and supply. They would shrink the consumer base and could cause an increase in risk aversion for migrants and in their savings rate. On the supply side, even without large deportations, labour participation could fall if illegal migrants stop working for fear of deportation. These impacts could be significant as the Department of Homeland Security estimated that illegal migrants numbered about 11mn in 2022 (about 6% of the labour force).

Large, broad tariff increases could have a negative short-term impact on investment though in the longer run they could lead to investment in manufacturing. Implementation will be key, including maintaining a stable and predictable business environment.

Market Consequences

Markets have recently turned pessimistic on the economy and are now pricing 2.3 cuts in 2025, against 1.1 two weeks ago. I do not share this pessimism as the foundations of the expansion are solid and I expect the administration to maintain pro-growth policies and strive for a more predictable policy and business environment. Also, if I am wrong on the administration’s policies, I see them as more detrimental to supply than demand. This suggests the risks to inflation remain skewed to the upside. Therefore, I still expect no 2025 cuts.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)