ICE Fixed Income Monthly

The dynamics of an “OK” American economy

I recently spoke with an old friend and mentor Gary Cohn for our ICE House podcast. Gary is Vice Chairman of IBM, former Goldman Sachs President and COO and former head of the National Economic Council. During our dialogue, he shared similar views to my own on the interesting dynamics at play in the US economy. These dynamics go some way to explaining why the long-forecast US recession has thus far been averted.?

Specifically, Gary pointed to two powerful and opposing forces at play in the form of the Federal Reserve and the federal government. While both have a mandate to support economic growth, their actions are effectively neutralizing each other.?

First, the Federal Reserve is acting on a data-dependent basis. To counteract high inflation, they’re following a playbook based on historical data: raising interest rates in a bid to tighten financial conditions and slow the economy. Yet giving excessive weight to historical data has proven challenging for them amidst a situation today that is unprecedented — the record books don’t reflect another period in history when the country experienced a major global pandemic, following years of quantitative easing that left the US economy with zero or negative real rates. Among other factors, add to the mix the acceleration of the development and adoption of certain technologies, supply chain shortages that caused price dislocations and geopolitical issues, and we find ourselves with a unique recipe indeed.?

Second, and at the same time, the federal government has continued spending to support demand, amid a rate hike cycle that’s been remarkable for its pace and magnitude. The government is creating projects and putting people to work, boosting wages, in hopes of creating a multiplier effect that supports growth in personal consumption. Interestingly, a key mechanism by which rates affect the economy -- the housing market -- has been less effective than previously thought, given that over 75% of homeowners locked in mortgage rates below 5% while rates were low. Nevertheless, rate increases have still had an impact. Gary suggests that real-time inflation is probably below 2%, and that the US may already be in a disinflationary cycle. In other words: the Fed have likely achieved their mandate, though it may not be immediately apparent in the data.

Fortunately, the market has absorbed rate increases relatively painlessly, with consumers able to shoulder higher costs without a substantial slowdown in economic growth. But while the central bank continues to look to history for a situation without “historical data,” the outlook remains muddy. It’s one where the economy may continue to grow, yet the cost of credit remains high. It’s one where there will likely be housing supply shortages as demand is muted by higher rates. It’s an outlook for an “OK economy.” What’s not OK, are the knock-on risks in a backdrop of high credit costs -- like potential bank downgrades, which could spiral into very negative multiplier effects. And in a globalized world, with concerns around Chinese economic growth, can we really afford to have an “OK economy?”

Read more in this month’s Fixed Income report: https://www.ice.com/solutions/fixed-income/ice-fixed-income-monthly-report??