Against the Wind: Headwinds Could Change the Course of the Economy

Throughout 2023, the U.S. economy has stayed resilient in the face of rapid monetary policy tightening; consumer demand has stayed solid, and the labor market has remained unflinching. Gross domestic product (GDP), adjusted for inflation, rose at a 2.4% annual rate in the second quarter, up from a 2% growth rate in the first three months of the year—far stronger than forecasters expected.

Consumers led the way, as they have throughout the recovery. Business investment rebounded in the second quarter, while increased spending by state and local governments also contributed to growth.

The persistent strength of the economy has surprised economists, many of whom believed that high inflation—and the Federal Reserve’s efforts to stamp it out through aggressive interest-rate increases—would lead to a recession, or at least a clear slowdown in the first half of the year.

Despite numerous headwinds associated with inflation and interest rates, U.S. consumers have not closed their wallets altogether. This trend cannot hold, in our view. We believe there are several headwinds that could, depending on their resilience,  slow the economy going forward.

The factors driving the continued strength of the economy in 2023 may be exactly what undermines growth in 2024; certain favorable economic trends may start to unwind.

Households built up sizable cash piles during the pandemic thanks in part to government stimulus, but those reserves are dwindling. By June 2023, households held less than $190 billion of the aggregate $2.1 trillion in excess savings accumulated during the pandemic through March 2023. By the third quarter of 2023, that excess is likely to be depleted, according to an estimate from the Federal Reserve Bank of San Francisco.

Credit card balances are rising. Although unemployment remains low, job growth and wage growth have slowed. Many economists think consumers are likely to pull back their spending in the second half of the year, putting a drag on the recovery.

Additionally, new student loan repayment requirements will begin to impact consumers later this year. Thus, while we forecast that overall consumer spending will grow in the third quarter of 2023, we anticipate a contraction in the fourth quarter of 2023 and into 2024.

The Bills Come Due

Almost 43 million borrowers with a total of $1.6 trillion in federal student loan debt will need to start repayments after the expiration of a pandemic-era stimulus measure on Oct. 1, 2023. On average, the amount owed is $28,950 per borrower. According to research from the Federal Reserve Bank of New York, the average student loan monthly payment is $393.

But with this amount added to the average bill payment of $400 a month, many borrowers will be faced with more than they can afford to pay, putting them at risk of becoming delinquent on other debt products including credit cards and auto loans.

Credit card debt is booming, the result of higher prices caused by inflation, rising interest rates, and strong consumer confidence, as well as 24 million new credit cards issued in the first quarter of 2023. Credit cards almost always have a higher interest rate than student loans. The average rate for a credit card is now 24%, the highest it has been since 2019, according to LendingTree.

The New York Fed notes that credit card debt is the most prevalent type of household debt, with balances in the second quarter hitting more than $1 trillion. More than two-thirds of Americans had a credit card in the second quarter of 2023, up from 59% roughly a decade earlier. Balances were more than 16% higher in the second quarter compared with a year earlier. Fed researchers say the rise in balances reflects both inflationary pressures as well as higher levels of consumption.

Rising balances could strain some borrowers, including those who are scheduled to begin repaying student loans, the researchers noted. A recent survey by the financial services company Empower found that a third of households with student debt expected their monthly loan payments to be at least $1,000, and that many were preparing for “significant” lifestyle and budget changes when repayment begins.

Those planned adjustments include cutting back on dining out, as well as taking on more credit card debt. That could prove expensive, especially for people who don’t pay their card bill in full each month.

From Debt to Delinquency

After declining sharply at the beginning of the pandemic, delinquency rates remained roughly flat in the second quarter of 2023. The share of debt newly transitioning into delinquency increased for credit cards and auto loans, with increases in transition rates of 0.7 percentage points for credit cards and 0.4 percentage points for auto loans.

Compared to other debt categories this quarter, credit card balances saw the most pronounced decline in performance following a period of extraordinarily low delinquency rates during the pandemic. Student loan performance was unchanged, with reported delinquencies at historic lows as the federal repayment pause remained in place until August 31.

As debt has risen, so have late payments: in the second quarter of 2023, 7.2% of credit card accounts were 30 days overdue—the highest level in 11 years—and delinquency rates rose to 3.18% (up from 3%). According to the Fed, neither of these numbers is shocking; the agency sees delinquency rates returning to pre-pandemic levels; these rates had eased only temporarily due to stimulus checks in 2020 allowing people to increase their savings.

Retirement account balances are up in 2023, despite recent reports from Fidelity, Bank of America, and Vanguard that showed hardship withdrawals also on the rise. The number of people who made a hardship withdrawal during the second quarter of 2023 surged to 15,950, an increase of 36% from the second quarter of 2022, according to Bank of America.

According to Fidelity, the percentage of 401(k) participants with a loan outstanding also increased, as did the share of those who took out hardship withdrawals, which reached 1.7% in the latest quarter. This data is a sign that, amid sky-high interest rates and two years of high inflation, Americans are looking for extra cash—and willing to tap their retirement funds to find it.

More Fed Moves Possible

While we no longer see a recession as likely, the risk of a downturn is still very elevated. One way this risk could materialize is if the Fed continues hiking rates. Recession risks could also materialize if the typically delayed effects of the Fed’s tightening kick in.

At a conference in Jackson Hole, Wyoming, in late August 2023, Fed chairman Jerome Powell said: “We are prepared to raise rates further if appropriate and intend to hold policy at a restrictive level until we are confident that inflation is moving sustainably down toward our 2% objective.” The Fed chair also noted that officials would “decide whether to tighten further or, instead, to hold the policy rate constant and await further data.”

That statement suggests that the central bankers are not determined to raise interest rates at their upcoming meeting on September 20, 2023. Instead, they might wait until later in the year. Meetings are set for November 1 and December 13, and the Fed may wait until after those meetings before deciding whether borrowing costs need to climb further.

Powell also emphasized that the economy could be taking time to react to the policy moves already made, and that conditions are unusual in the wake of the pandemic: for example, job openings have fallen without pushing up unemployment.

A New York Fed indicator that tracks the difference between three-month and 10-year Treasury yields is pointing to a 66% chance of a contraction in the next 12 months. The personal consumption expenditures price index, the Federal Reserve’s preferred inflation measure, rose 4.1% from June 2022 to June 2023. Meanwhile, the consumer price index was up 3.2% over the past 12 months as of July. Both rates are higher than the Fed’s 2% target for inflation. While the rate of inflation has come down, that doesn’t mean prices have come down; it just means that they’re rising at a slower pace.

A recent survey of senior loan officers by the Fed shows that many banks and firms are dialing back and reducing credit. A net 51% of banks said they had tightened lending standards for larger and medium-sized businesses over the last three months. That’s up from roughly 46% of banks who said the same in the first quarter of 2023. Excluding the pandemic onset, the latest survey shows the largest net share of banks reporting tighter standards since the 2008 financial crisis. For loans to small firms, a net 50% of banks said they tightened standards to about 2.5 percentage points above the first quarter.

The survey results show that businesses seeking a loan to buy equipment or hire staff have a higher bar to clear than they’ve had in years. For everyday Americans, it could be more difficult to get a loan to buy goods—with ripple effects for companies that sell them.

Yet Another Government Shutdown Looms

A new budget crisis looks likely to arrive as the fiscal year ends on September 30. The House reconvenes on September 12 and has only twelve working days to pass a budget. There are two options—either a “continuing resolution” to postpone the budget fight to December, or a government shutdown. While Senate Republicans appear to favor an agreement to pass the 12 appropriations bills needed to fund government operations before the start of the new fiscal year, House Republicans are ready to make demands that will be difficult to pass through the Senate, where Democrats are in the majority. So, in a rerun of previous partisan political drama, Congress is on track to trigger a government shutdown on October 1, 2023.

A shutdown may seem as if it would lead to some quick and dramatic savings. Non-essential employees are furloughed, the government stops writing checks for huge swaths of programs, and even essential employees come to work without getting paid. But shutdowns end up being more expensive than just the cost of keeping the government operating.

Budget experts have found that a shutdown hurts the nation’s finances in a number of ways.

Furloughed workers almost always get paid retroactively for the time they were out—which means taxpayers are laying out money without getting any work in return. Museums and national parks can’t collect fees and revenues from other sources like gift shops. Perhaps most importantly, federal workers spend thousands of cumulative work hours preparing for the event and recovering from it, literally shutting down their departments and then restarting them once the government reopens. The shutdown and reopening process itself requires paid work that is utterly unnecessary to the normal business of running the country, and it takes time away from safety inspections, reviewing research grants, and processing applications.

Shutdowns carry a cost to the economy as well. The Congressional Budget Office (CBO) estimated that the 2018-19 shutdown reduced Gross Domestic Product (GDP) by a total of $11 billion, including $3 billion that will never be recovered. On top of that effect, CBO notes that longer shutdowns negatively affect private-sector investment and hiring decisions as businesses cannot obtain federal permits and certifications, or access federal loans. A 2019 Senate report found that the three government shutdowns in 2013, 2018, and 2019 cost taxpayers nearly $4 billion.

Conclusion: Prepare for Turbulence

The Atlanta Fed currently has GDP growth for the third quarter forecast at 5.6% while the New York Fed has forecasted 2.25 which we believe is more realistic. Any one of the numerous headwinds noted in this article, which the economy has to face going forward, could result in a more significant downturn than expected.

While we continue to believe that a recession is no longer a sure thing, we do expect the growth in the economy to slow after the third quarter of 2023.

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