Expect a pause, not a pivot, as savings fuel spending

Putnam Fixed Income team, 11/18/22

  • Inflation uncertainty is likely to remain high for longer than expected.
  • Excess savings have accumulated in developed and emerging economies, making consumers willing to pay more for goods and to demand higher compensation for work.
  • The Fed and other central banks seem determined to loosen labor markets and readjust asset valuations, which might require a long period of high rates and high volatility for risk assets.
Inflation is a global phenomenon. It is due partly to excessive stimulus implemented in many countries during the Covid-19 pandemic and partly to the limitations of the post-pandemic labor supply. But it is also due to the introduction of lockdowns: When people chose to or were told to stay home, their consumption decreased and they accumulated savings. Those savings are now affecting spending and labor market participation and slowing central bank efforts to reduce inflation.

The lesser-known "lockdown stimulus"

Personal consumption is typically more stable than personal incomes. Even in recessions, consumption decreases less than incomes do, because people tend to spend their savings and sometimes take on debt. In that respect, the pandemic was the opposite of a recession. Many people consumed less but kept their jobs and income. As a result, household savings increased. This was, in essence, a stimulus, and equivalent to helicopter money (central banks making payments directly to households).

The amount of global excess savings today is a function of both policy easing and of stringent mobility restrictions introduced during the pandemic. Levels vary across countries. In terms of restrictions, the U.S. was behind many developed countries with a single three-month lockdown. Personal consumption continued to recover with setbacks during other Covid waves. European countries, however, had extended lockdowns during the winters of 2020–2021 and 2021–2022. Personal consumption in European countries was more disrupted, and its recovery has been more protracted. Among G10 countries, Sweden had a more relaxed approach to lockdowns, and its consequent lockdown stimulus was small. Japan was not hit hard in the first Covid wave, but it introduced tougher restrictions later, and its household consumption is still in recovery mode.

Excess savings have continued to accumulate, as lockdowns increased personal savings in all developed economies as well as in many emerging market countries.

Figure 1. U.S. incomes spiked early in pandemic and sustained spending

U.S. household income and spending, 1/31/12–9/30/22 (real, in billions of dollars)

Source: Bureau of Economic Analysis. For illustrative purposes only.

Figure 2. U.S. lockdown stimulus lifted savings levels

U.S. commercial bank deposits, 1/31/12–9/30/22 (in millions of dollars)

Source: Federal Reserve. For illustrative purposes only.

Figure 3. Euro area lockdown stimulus lifted savings levels

Euro area deposits of residents, 3/31/12–6/30/22 (monetary financial institution liabilities, in millions of euros)

Source: European Central Bank. For illustrative purposes only.

Figure 4. Japan savings jumped during 2020 and continued rising

Japan commercial bank deposits, 1/31/12–8/31/22 (in hundreds of millions of yen)

Source: Bank of Japan. For illustrative purposes only.

The well-known fiscal and monetary stimuli

When the Covid-19 pandemic emerged, its dangers and its treatment were highly uncertain, and financial markets were near collapse in a matter of days. The Federal Reserve and other central banks responded vigorously with rate cuts, large-scale quantitative easing (QE), and special facilities to prevent meltdowns. In hindsight, only the measures to restore market functioning were actually needed. Rate cuts and extended QE were excessive.

Fiscal policymakers also joined in, with everything from stimulus checks to sector bailouts to loans that could be forgiven. These were extras on top of the inherent lockdown stimulus. Thinking that inflation was a thing of the past, central bankers did not hesitate to finance the fiscal expansions. Households ended up with excessive wealth.

This wealth makes many consumers willing to pay higher prices and seek higher compensation to participate in the job market. Firms, regaining their pricing power, are happy, too. Labor costs and commodity prices might be rising, but they can pass on rising costs of production to final consumers.

Since the current inflation is sustained by tight labor markets as well as strong household wealth, a drop in labor demand might not be enough to bring inflation down. It is also not clear that an increase in unemployment per se would be sufficient to kill off inflation.

Asset prices need to fall to reduce inflation

A sizeable decline in asset prices and personal wealth is essential for inflation to come down. A considerable drop in asset prices can resensitize households to prices, especially those in the richer part of the income spectrum, and might bring some of them back to the labor market. In the U.S., the older age groups' labor market participation has not recovered much after falling in the early days of the pandemic. Retirees' spending and labor market participation are more sensitive to asset prices than those of other age groups. If their (capital) income declines further, they might both come back to the labor market and spend more cautiously.

On its own, however, a sustained fall in household wealth is unlikely to bring down inflation absent a significant deterioration in employment. As long as the labor market stays firm, households will keep spending, sustaining inflation. In other words, a soft-landing scenario that does not involve significant job losses is unlikely to solve the inflation problem.

The Fed and the other central banks seem determined to loosen labor markets and readjust asset valuations, which might require a relatively long period of high rates. Although markets have priced in higher policy rates, neither interest-rate markets nor risk asset markets have priced in rates staying high for longer. Many firms and households might ride through a short period of higher rates, but they are not prepared for a long period. Their funding and refinancing needs might be low in the near term, but they will rise in the medium term. If asset prices do not fall significantly and unemployment does not rise quickly, we might have to wait longer, until these funding needs increase, to see the impact of higher rates. In the meantime, central banks will have to continue to hike, keep rates high, and deal with financial market dislocations with targeted measures.

A pause before climbing higher?

In the coming months, inflation will likely be coming down from recent highs due partly to the base effects and partly to the price declines in durable goods and commodities. At the same time, job growth will likely slow, and some measures of wage inflation will ease, making it simpler for the Fed to prepare the market for a slower pace of hikes. The optics will look good and will add to the never-ending talk of a Fed pivot.

However, a pause is not equal to a pivot to reducing rates. Rather, the Fed can pause and wait with a high level of rates for convincing signs of disinflation. If inflation does not decline enough, the Fed might revert to a tightening phase, as Philadelphia Federal Reserve President Patrick Harker recently said. Less but still strong wealth effects will continue to be a headache for the U.S. and other countries.

Inflation uncertainty is likely to remain high for longer than expected, but central banks might redirect their attention should two other scenarios emerge: financial stability concerns or rising unemployment. G10 central banks in Australia and Canada, along with the European Central Bank, are already leaning in this direction. If, for fear of breaking something or under political pressure, the G10 central banks quickly choose to guide the market toward easing, high inflation would stay longer. In that case, the central banks can control the front end of the interest-rate curves, but the other parts of government bond curves would not behave well. Either private investors would demand a higher risk premium in bonds, or the central banks would have to maintain relatively high rates longer, avoiding another round of QE. In either scenario, rate volatility would be high for longer. For risk assets, high interest-rate volatility is not good news, but even a real pivot would not help much if the pivot to rate cuts happens due to concerns of a looming recession.

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