Pricier Necessities Hinder Household Savings

Summary

• ‘Excess savings’ have been spent, but the savings rate is not recovering.
• The low post-pandemic savings rate likely reflects pricier basic necessities.
• If so, a recovery in savings would require either faster real wage growth or a decline in the relative cost of basic necessities. Neither appear likely.
• A low and stable household savings rate supports strong GDP growth and therefore suggests Fed cuts would be insurance against recession rather than a response to a surprise recession.

Market Implications

• I still expect a single 2024 cut at the November or December FOMCs, against the market pricing 2.6 cuts by December 2024 and 3.3 by January 2025.
• We like to trade this view as a tactical short Jan Fed Funds.

End of Excess Savings

A low household savings rate is a key driver of my positive growth outlook. In this note, I explain why I expect it will remain low.

I was never a big fan of the excess savings hypothesis. It explained the low post-pandemic savings rate by households running down the high savings built during the pandemic. This presumed we knew what ‘trend savings’ were, which I think is impossible in real time.

Regardless, the San Fransico Fed, a key proponent of this view, has admitted excess savings have been fully spent since March 2024. As a result, you would expect the household savings rate to rise, but it has not. The San Fransico Fed economists think this could reflect a strong labour market, higher wealth, and higher debt.

Wealth and debt have played a role in the secular decline of the household savings rate (Charts 1 and 2). Yet they do not seem to explain much of the post-pandemic decline.

Household debts are roughly unchanged compared with before the pandemic. Net worth is higher than pre-pandemic, but the distribution of US wealth is highly skewed. The top 10% wealthiest US households hold two-thirds of total wealth. This limits the economy-wide impact of changes in wealth on consumption and savings.

Wealth was likely not the main factor in the post-pandemic lowering of the savings rate. I think the higher cost of basic necessities is the key driver.

Keeping Body and Soul More Costly Than Before Pandemic

Economists like to think of savings as driven by expectations of permanent (i.e., long-term) income. That is, households save in such a way as to smooth out consumption through their lifetime. The permanent income hypothesis implies the savings rate is largely driven by the difference between current and long-term expected income. Some of this happened during the pandemic, when household savings surged because of the very large government transfers and the associated increase in income.

One problem with the permanent income hypothesis is it assumes households are always able to save (on top of being rational, having perfect foresight, access to credit, etc.). In reality, when households make barely enough to cover their basic needs (e.g., food, shelter, or healthcare), they lack the capacity to save.

The data shows large numbers of households are just getting by. The latest Fed Survey of Households Economics and Decisionmaking shows 28% of households are either ‘just getting by’ or ‘finding it difficult to get by’ (Chart 3). Also, 37% of households would not be able to cover an unexpected $400 expense.

What is the minimum a US household needs to spend to keep body and soul? Household spending can be broken down into three broad categories.

1. Unavoidable: payments households must make or suffer negative income and legal consequences (i.e., tax and interest payments):
2. Basic necessities: these are the categories of expenditures households need to keep body and soul (e.g., food, energy, shelter, cars and trucks, healthcare). I have included cars and trucks, ‘cars’ thereafter, since the US has limited public transportation and most Americans must drive to work.
3. Discretionary spending: these include furnishings and household equipment, recreational goods and services, clothing and footwear, transportation services, hotels and restaurants, and financial services.

This is a broad characterization. For instance, there is discretion on how much to spend on food and shelter etc. But expenditures in the basic necessities category tend to have lower income elasticities than expenditures in the discretionary category.

Chart 4 displays spending on categories 1 and 2 (i.e., ‘life necessities’) relative to before-tax income. It shows:

• Households spend upwards of 55% of their before-tax income on basic necessities, leaving only about 45% to be divided between savings and discretionary spending.
• The share of income spent on unavoidable payments and basic necessities has been trending up from the 1970s to the early-2010s.
• This is largely the result of higher spending on healthcare, which now represents 16% of pre-tax income, up from 6% in the 1970s. Excluding healthcare, spending on basic necessities would have fallen to 40% of income, from 46% in the early 1970s.
• Spending on basic necessities is higher than pre-pandemic, due to higher spending across all categories except healthcare, with spending on shelter, interest rates, and food registering the largest increases.

There is strong evidence the cost of basic necessities impacts the savings rate.

Savings Rate Unlikely to Rise

Chart 5 plots the savings rate against spending on basic necessities. It shows a strong negative correlation between the two series.

If my explanation is correct, an increase in real wages and/or a decline in the relative price of food, shelter, energy, cars, and shelter would be needed for a recovery in the savings rate.

A marked increase in real wages appears unlikely as the labour market is normalizing while labour supply is increasing (Chart 6). Also, the relative wage gains made by lower-paid workers during the pandemic have disappeared, possibly due to a large increase in low skill, undocumented migrant workers.

There is no sign the relative prices of basic necessities are falling (Chart 7). Cars are the only item whose price is falling markedly faster than the overall PCE index. Shelter costs are still rising faster while energy and healthcare services relative prices are stable. Relative food prices are falling but gradually so.

Market Implications

A low and stable household savings rate supports steady consumption growth and more broadly continued GDP growth close to trend. This aligns with the recent retail sales data positive surprise and with recent Fed speakers communicating a positive economic outlook. For instance, Governor Christopher Waller stated yesterday he expected ‘no significant deterioration in the labour market in the next few months.’

A steady growth outlook suggests Fed easing this year would be more insurance against, rather than a response to, an unexpected recession. This suggests a shallow easing cycle. I therefore still expect a single 2024 cut at the November or December meetings, against the market pricing 2.6 cuts by December and 3.3 by January 2025. We like to trade this view can as a tactical short Jan Fed Funds.

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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

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(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.)