The numbers keep rolling in to confirm: things look very good in the U.S. economy. Spending by U.S. households rose 1.8% in January from the previous month, the Commerce Department said on Friday. Employers added half a million jobs in January, more than twice as many as economists had predicted. Retail sales jumped in January at a higher rate than they had for nearly two years.
You’d think it would be time to kick back, sip a martini, and celebrate. But it’s not. The continued strength of the U.S. economy means the Federal Reserve’s efforts to slow inflation by increasing interest rates are not working as quickly as they’d hoped. Inflation rose 5.4% in January from a year ago, according to data from the Fed’s preferred index released Friday.
The Fed wants inflation to be around 2% and will keep increasing interest rates until it gets near that target. (Whether it should give up on that target is a question the Fed doesn’t seem interested in pursuing at the moment.)
“The consumer is the stallion running wild and the Fed is the cowboy—and the Fed will win at the end of the day,” says Mark Zandi, chief economist at Moody’s Analytics.
Already, the Fed has raised interest rates from near zero in April 2020 to a 15-year-high of above 4.5%, the most aggressive policy since the 1980s. Officials don’t expect to reduce interest rates until at least 2024.
If you’re not someone who needs to borrow a lot of money in the foreseeable future to buy a house or make another big purchase, you might not think that the Fed’s moves are relevant to you. But they are. Higher interest rates also increase the cost of having a balance on a credit card. They make it more expensive for businesses to borrow money, and when companies have higher expenses, they’re going to look to either raise prices or cut spending. That often means laying off workers, one reason we’ve seen tens of thousands of tech layoffs in recent months.
What happens next as the Fed works to slow inflation could be especially painful for those at the bottom half of the income distribution in the U.S. Consumer spending is what’s driving the hot economy right now, but it’s mostly consumers in the top half of the income distribution who are doing this spending, Zandi says.
Recent data suggests that the U.S. economy isn’t going into a recession anytime soon. These higher-income households saved so much money during the pandemic that they seem relatively unphased by inflation, continuing to shop and eat at restaurants and travel, despite rising prices. But low and middle-income households have run through the savings they accumulated during the pandemic, Zandi says, and are reeling from high prices. They are also finding that it’s getting more expensive to push back a credit card payment a month or two.
“For families at the lower end of the income spectrum, shifting the burden of debt on a monthly basis can rapidly become unbearable,” says Gregory Daco, chief economist at EY Parthenon. He predicts a K-shaped consumer spending pattern this year, with higher-income households continuing to spend, while lower income households slow their economic activity.
There are already signs that this is happening. Darden Restaurants said in an earnings call that households making less than $50,000 were eating less frequently at its Olive Garden and Cheddar’s restaurants, but it was still seeing strength with guests in higher income households. Meanwhile, credit card debt is at a record high while new delinquencies are rising after two years of relatively low numbers.
Daco estimates that the top 40% of households account for about 60% of consumer spending—and that their share of spending has increased during the past few years as they’ve accumulated money while largely staying home. These wealthier households can continue to keep spending and prop up the economy for a while, he says.
But eventually, the economy is going to feel the loss of lower-income households and their spending power. Especially if higher-income households start to balk at high prices and high interest rates. There’s lots of reasons to be optimistic, sure—but that also means there are reasons to worry.
“Household finances are healthy,” says Daco, “but we are starting to see cracks in the foundation.”
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