As at 5 July 2023
Author: Gavyn Davies, Chairman
- The US economy has continued to defy those who have been predicting an imminent recession.
- Furthermore, the latest set of US inflation data has been somewhat more encouraging than expected.
- The economy is therefore still benefiting from now-familiar supply-side improvements, including lower energy prices, rising labour participation and repaired supply chains in goods sectors.
- Aggregate demand has also remained firm this year, partly because of lower headline inflation driven by supply improvements.
- Further support for demand has stemmed from a run down in excess savings balances after the pandemic and lags between the impact of monetary policy tightening and financial conditions.
- Interesting new research by the Fed suggests that the combined effects of these two demand-side factors will begin to fade by the end of 2023, making the economy more vulnerable to a demand-side slowdown.
- Meanwhile, in the EU, early data for June has indicated that the European economy has weakened further and is much nearer to a full-blown recession than the US.
- Overall, a clash between a slowing economy and hostile monetary policy seems far more probable in the EU than in the US, at least for now.
Recent editions of Chairman’s Views, have argued that supply curves in the advanced economies have shifted to the right this year, triggering a boost to real output and bringing down headline inflation, notably in the US. Standard economic models predict that a shift to the right in the aggregate supply curve should also lead to an increase in aggregate demand, but in the first instance this would represent a shift along the demand curve, rather than a structural shift in the curve itself. Lower price inflation – caused, for example, by lower oil prices – has probably had this effect since October 2022, as evidenced by the significant gains in real personal disposable income since then.
It is likely, however, that there have been other factors that have contributed to the buoyancy of demand in recent quarters. One such factor has been the hangover of excess savings balances after the fiscal easing during the pandemic in 2020-21. Another has been the fact that the significant monetary tightening since November 2021 has worked into the economy – via monetary conditions – with the normal long lags, implying that the full effects on demand have not yet become apparent. Both factors have recently been the subject of recent research published in the FEDS Notes series of papers.
The behaviour of excess savings balances has been widely followed in the financial markets since the pandemic There are three main conclusions to draw from the new Fed research on this topic (see graph below):
- The stock of excess savings built in the US during the pandemic peaked at almost 7% of GDP in mid-2021, but this has now fallen sharply. This has strongly supported demand up to now, but excess savings have actually turned negative in 2023Q1, implying that little further boost to the economy is to be expected from this source. In fact, this boost may move into reverse.
- In other advanced economies, the peak level of excess savings was around 6% of GDP, similar to the US. However, the draw-down in their stock of savings has been much less than that seen in the US, and excess savings still stand at about 4% of GDP. This implies that there may be a significant further boost to demand from reduced savings in these countries before normality is reached, though this expansionary force outside the US is operating only very gradually.
- In the emerging economies, excess savings have been much larger during the Covid-19 recession than in previous downturns and they have not yet started to decline in a meaningful way. In China, excess savings have edged down to about 5% of GDP now, from a peak of around 7% of GDP two years ago. This gives scope for a further significant boost to demand to come from this source in the next few quarters, but there is little sign that this will happen quickly.
Overall, therefore, the US stands out as the major country that has depleted its holdings of excess savings the most, probably leaving less boost to demand to come from this source in coming quarters. Other countries still have the majority of their stimulus to come from this source.
Evolution of savings rates during the COVID-19 pandemic
Source: Haver Analytics¹
Now let us turn to the impact of monetary tightening on US demand, operating via financial conditions. The second Feds Notes paper that is highly relevant to the current US economic situation presents a new Financial Conditions Index (FCI-G), which includes several key asset prices that are crucial intermediaries between policy interest rates and the real economy. These “broad” FCIs have been widely used in financial markets for at least 25 years, and the concept has often been mentioned by Chairman Powell, but the Fed has not previously published any version of such an index. Instead, regional Feds have presented other versions of FCIs that are designed to measure much narrower concepts, such as the level of stress within the financial system itself.
Apart from the fact that the new index is estimated from within the Federal Reserve research team, the FCI-G has some advantages over independent estimates, such as the well-known Goldman Sachs FCI. For example, the index is directly intended to calculate the impact of changes in financial conditions on real GDP growth in 12 months’ time, using the lag structure in the Fed’s main macro model (stretching backwards for 1-3 years). The FCI-G combines the effects of present and previous asset prices to predict the full impact of changes in financial conditions on GDP growth at the relevant policy horizon of one year. The latest results are shown here:
Financial Conditions Impulse on Growth, with 1- or 3-year Lookback Window
Source: Haver Analytics²
The black line shows the impact of financial conditions on real GDP growth when the historic behavior of asset prices is allowed to stretch back 3 years, while the red line uses information stretching back for only one year. Both indices currently show that real GDP growth will be restrained by about 0.75% in 12 months’ time by the current and lagged effects of the tightening in financial conditions that has occurred in recent quarters.
These are the most restrictive readings for the FCI that have been recorded since the Great Financial Crisis, though there has been some easing in the past few months, especially on the 1-year FCI. Furthermore, the new index suggests that the impact of FCI tightening on GDP growth up to mid-2024 will be substantially more restrictive than is suggested by equivalent FCIs estimated by Goldman Sachs and others. In the June FOMC statement, the Committee suggested that two further policy rate increases of 25 bps each are likely to occur before the end of this year. All else equal, this would be expected to push the FCI-G further into restrictive territory.
Overall, these Fed research papers therefore suggest that the boost to the economy from declining excess savings will probably run out of steam by the end of 2023, if it has not done so already. In addition, financial conditions (allowing for lags) are likely to remain in extremely restrictive territory for a prolonged further period. Taken together, these developments are likely to lead to a significant slowdown in GDP growth from the present rate of 1.5-2.0%, though an outright recession still seems improbable over this horizon.