Since earlier this year and even further back, many individuals have been asking a question, one with no easy answer: Why is this time different?
Well, even as economists, it’s admittedly difficult to determine exactly what the future holds. This is just as true even in what many have called the most telegraphed recession in history. To answer the question the most accurately, it is important to evaluate certain elements within this economic cycle that might differ from others. These notable differences could make a huge difference, meaning that Americans are better able to weather the higher interest rate storm than in previous cycles.
To expound on this even more, it’s important to consider what a typical economic cycle looks like, so the characteristics of this cycle stand out as being different:
What is a Typical Monetary Cycle?
The economy overall has four phases that are referred to differently by different experts. Generally, it includes the following phases:
Phase 1 Expansion
This is when interest rates are low. During this phase, it’s easy to borrow money during this phase. Consequently, the demand for consumer goods will grow. There will be an increase in production, which will lead businesses to hire more and more workers, expand their operations and invest in capital. The Gross domestic product (GDP) will also rise, which will further enhance this boom cycle.
Phase 2 Peak
Here, the economy will reach its maximum growth rate. During this time, some companies may be unable to meet the growing demand of the boom, so they will have to invest in more expansions, which will often be passed on to consumers at higher prices. This will cause a topping-off or bubble to build in the economy.
Phase 3 Contraction
At this stage, consumer spending, corporate profits, and the like will begin to fall. Investments will be relegated to safer options. In many cases, income and employment will begin to decline and overall activity will slow. Stocks enter a bear market and recession follows.
Phase 4 Recovery
Although this article isn’t about the recovery after the recession, it’s important to note this last phase. This is when the economy hits its low and bottoms out. The good news is this begins a new cycle. Stock values will begin to rise and production will once again ramp up along with employment, income, the GDP, and business expansion.
What This Cycle Looks Like
While the above information outlines just a run-of-the-mill simplified market cycle, we are looking at this one in particular and why it might not be as bad as many people are fearing. In normal cycles, the Federal Reserve decreases interest rates. This is done to reactivate the economy. It comes along with lower interest rates and will eventually prompt more lending by banks.
Decreasing Interest Rates: When the Federal Reserve does this, they are buying treasury from the market and forcing liquidity into the market overall. Financial institutions and banks will then pass these funds on to consumers, via loans and increase the overall money supply.
The cycle will reverse when the Fed does the opposite and sells Treasury into the market. This is done to dry the market. The end result is banks lending less money, which reverses the money supply growth. It’s important to note that on occasion during the expansion phase— when borrowing increases to a frenzied level— the end result can mean trouble for households and individuals who cannot keep up with their debts, especially in the case of lost or reduced employment. The same can be said for firms when credit becomes more and more affordable and they increase their investments.
What Does This All Mean?
To put it simply, the above is what a normal cycle looks like. Typically, the Fed starts increasing interest rates triggered by expansion and the end result is individuals losing their jobs and finding themselves in trouble in a downturn or recession. However, the reason why this time could be different is that the period during the COVID-19 pandemic was not normal. It wasn’t typical and it didn’t represent a regular economic cycle.
Yes, it’s fair to say that money skyrocketed during this time, but it isn’t accurate to say this was because banks lent out money to either firms or individuals. Instead, the money came from fiscal policies that paid out to virtually every American. These looked like this:
- $1,200 check for everyone in April 2020.
- $600 check for everyone in December 2020.
- $1,400 check for everyone in March 2021.
This is all in addition to the monies that were available through the Paycheck Protection Program or PPP loans available to businesses from April 2020 up until May 2021.
At the same time that all this money was rolling in, the economy was closed. It remained shuttered for months with virtually everyone buying their needed goods through mobile apps or other internet services. This was all due to the fear of contagion and required a change in how most of America shopped. This insurgence of funds also led to an excess in savings during the COVID-19 recession. How it is expected to look going forward is outlined in more detail in the graph above.
The Difference: The Missing Link
What all this means in terms of how this differs from a regular economic cycle that sees both growth and recession basically is the fact that if there is a credit contraction today or later in 2023, it would not impact households, businesses, or individuals as it would have during a standard tightening or contraction phase. Now, that doesn’t mean that interest rates aren’t moving upward. Admittedly, higher interest rates are even now pricing many Americans out of the housing market. However, it’s important to highlight that this is because of a weakening housing market and is not at the same level as the “crisis” that happened during the Great Recession.
In addition, while mortgage rates have increased considerably, this increase is primarily affecting Americans who are seeking to buy a new house or are facing issues with a current mortgage at higher rates. The majority of Americans, though, those who have a fixed very low mortgage rate, are not being impacted by this higher inflation. In addition, wages and salaries are increasing, which further reduces the burden of these mortgage rates on real income. Meaning it makes it easier for regular Americans to continue to pay their mortgages.
The bottom line is this is all good news. This is especially true if America does in fact enter a recession this next year, which is expected. Below is another helpful graph that looks at the debt service ratios and how they have continued to decline or remain historically low. This means today’s households are in a better financial situation than they have been in the past when the country was moving towards a potential recession:
Mortgage Debt High, But It’s Still Good
All this information basically means that although mortgage debt is historically high, mortgage debt service payments are historically low. This means they are at a historically low level when compared to the average disposable personal income level of Americans. Individuals today have enjoyed an increase in income for the last several decades. This means that the low-interest rates per debt and income have brought the household obligations ratio to a 60-year low.
Is There Any Bad News?
While all the above is true, there remains one problematic debt service ratio that cannot be ignored today and that is consumer debt. This includes automobile debt payments as well as credit card debt. Credit cards also have the additional problem of being liquid, meaning they are not fixed and can go up or down. This means the debt service payment ratio will only increase with higher credit card interest rates.
What is Going to Give?
The above information outlines why we believe that the U.S. economy will suffer a mild recession as compared to a deeper recession in 2023. There is still a possibility that we could experience a recession, but there is a chance it won’t happen simply because individuals and households are in a better financial position. One of the main factors will be determined by the labor market's ability to stay strong and not falter under higher interest rate pressures from the Fed.
Some individuals believe that the Fed should push the economy into a recession to bring down inflation. We disagree. Instead, the Fed needs to bring economic growth to below potential which currently is around 1.8% yearly. For comparison, the average economic growth throughout the past two years has averaged about 5.0%, which is way above GDP’s potential growth and is the main reason why inflation is high today.
If the Fed keeps economic growth below potential for several years, which we believe will be the case, then inflation will continue to slow down. Of course, this does require a bit of fine-tuning and course-correcting in the process to maintain the slowdown. Unfortunately, the Fed isn’t exactly known for its ability to fine-tune as they are blunter in their actions normally. Hopefully, though, they will show restraint. Of course, we know that Fed economists and officials have better and more timely information about the current state of the U.S. economy, and they know the issues better than we do. Therefore, we fully expect them to exercise restraint and patience when determining what monetary policies to implement moving forward. That is why we feel this time will be different.
Any opinions are those of Brockmeier Financial Services, LLC, and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of the strategy selected.