Economic hard landing is delayed but not cancelled

Two years ago, central banks around the world started hiking interest rates. At the time many commentators, including this one, predicted that the end of years of easy money would cause asset prices to collapse and economies to buckle. Yet no recession arrived. Indeed U.S. economic growth picked up after 2022. Following the briefest of bear markets, American stocks hit a new high.

In his book “Expert Political Judgment: How Good Is It? How Can We Know?”, published in 2005, the political scientist Philip Tetlock argues that experts often provide rationalisations for their forecasting failures after the event. One of the most common is “it would have happened except for…”. There is no shortage of such arguments to explain the absence of an economic hard landing.

To start, it is worth pointing out that the bears did not get everything wrong. Bond markets in 2022 suffered their worst 12-month performance since the introduction of British consols in 1753, according to Professor Edward McQuarrie of Santa Clara University. Many speculative investments have crashed. Commercial property markets in many parts of the world are in distress.

Nevertheless, the transmission mechanism between monetary policy and the economy appears weaker than in the past. Yields on long-term U.S. government debt have been lower than short-term bond yields for 18 months. Investors formerly considered such an inverted yield curve as the most reliable leading indicator of a recession.

Covid-19 stimulus lingered long after the emergency was over. During the pandemic, the federal government in Washington made vast transfers to American households. Excess consumer savings peaked at $2.5 trillion in September 2021, according to Julien Garran of the Macrostrategy Partnership. The subsequent drawing down of this savings pile has boosted consumption.

Furthermore, much of the liquidity provided to the financial system by the Federal Reserve in 2021 and 2022 initially flowed back into the central bank’s overnight reverse repo facility. Garran estimates that the recent outflow of these deposits from the Fed has pumped a net $1.25 trillion into U.S. markets, more than offsetting the impact of higher interest rates and the Fed’s shrinking balance sheet.

Jamie Lee of The Grantham Foundation has another explanation for why higher interest rates have not choked the economy. Before the financial crisis of 2008, central banks did not pay interest on excess bank reserves. As a result, commercial banks immediately felt the pain of tighter monetary policy. Lee points out that deposits at the central bank are the safest and most liquid form of money, used for settling transactions between lenders. In the past these deposits were scarce and, because they did not attract interest, expensive for banks to hold.

Since 2008, however, the Fed has been paying interest on reserves. They have become super-abundant, rising from $44 billion in March 2008 to $3.5 trillion by March 2024. When the central bank hikes interest rates, it therefore creates money which is paid into the banking system, boosting liquidity. “When the Fed ‘raises rates’, it leaves the bid-ask spread for final settlement money unchanged, at virtually zero. Tightening is not tightening after all,” Lee explains. In this sense, more restrictive monetary policy is actually easier.

There are two other reasons why the U.S. economy has shown itself less sensitive to higher interest rates. Torsten Slok, chief economist of Apollo Global Management, argues that both homebuyers and corporations took advantage of easy money conditions to borrow at low interest rates. Because interest payments on most U.S. residential mortgages are fixed for decades, homeowners have been insulated against rate hikes.

Meanwhile, large U.S. corporations extended the maturity of their debt during the pandemic. With the investment-grade corporate debt market having grown from $3 trillion in 2009 to $9 trillion today, American companies have become less sensitive to short-term movements in interest rates, according to Slok.

At the same time, large companies are now receiving more interest income on their deposits. This explains the curious fact that net corporate interest payments in the United States fell after the Fed raised interest rates.

The second reason for the U.S. economy’s resilience to monetary tightening is an extraordinary spending splurge by the government. The federal deficit in 2023 was $1.7 trillion, equal to 6.3% of GDP. This provided a strong tailwind for growth, employment, and corporate profits.

These various monetary and fiscal supports are now largely exhausted. U.S. aggregate demand and corporate earnings will face a squeeze when Washington reins in spending. Excess deposits in the Federal Reserve’s reverse repo facility are at a fraction of their peak. Consumers have largely spent their pandemic-era excess savings.

Meanwhile, tighter monetary policy is pinching. The U.S. commercial real estate market is a slow-motion train wreck: vacancies are sky-high and property valuations are down sharply. Hedges against higher interest rates, which typically last for three years, are expiring and are prohibitively expensive to renew. Defaults on commercial mortgage-backed securities are rising.

Many real estate borrowers are seeking to amend and extend their maturing loans. Owners of multi-family apartments — buildings divided into multiple homes — are struggling to pay interest on floating-rate loans, many of which are held by collateralised loan obligations. Apartment construction in the United States surged during the pandemic: a record one million multi-family apartments were under construction last year. Oversupply may further depress prices, hurting both real estate developers and lenders.

The leveraged buyout industry is wilting under the heat of higher interest rates. The International Monetary Fund recently warned of systemic risks posed by the $2.1 trillion “opaque and highly inter-connected” world of private credit dominated by private equity groups. Private companies which cannot access the bond markets are also suffering from higher interest costs. Hordes of corporate zombies are slowly returning to their graves.

The economist Milton Friedman famously said that monetary policy works with long and variable lags. Those lags may be longer and more variable today than in earlier times. But sooner or later, they end. Tetlock’s experts had another favourite comeback when faced with a mistaken prediction: “it hasn’t happened yet,” they said. Those who foresaw a hard landing that has so far proved elusive might say the same.
Source: Reuters Breakingviews (Editing by Peter Thal Larsen and Streisand Neto)