The economy is marching along like the Energizer Bunny. The latest quarterly real economic growth came in at 4.9% on an annualized basis. Consumption represents about 70% of all spending in the economy, and these households came out in full force this past quarter. 

Such growth is remarkable. We rarely see 5% growth, most recently briefly when COVID quarantines came to an end and cabin-feverish consumers made up for lost time. This time around, there is no easy explanation for why people are spending. Supply constraints eased some time ago, pent-up demand has been satisfied, and the government is no longer sending out feel-good checks. 

Current interest rates also make such strong spending more surprising. We haven’t seen 5% 10-year Treasuries for decades, and credit card, auto, and mortgage interest rates have all been rising rapidly. Rising interest rates are precisely the effect the Federal Reserve had hoped to trigger. They certainly did not anticipate really strong growth in spite of their best efforts. After all, while the Fed is typically relatively ineffective in accelerating an economy, they have powerful tools to slow down investment and consumption through higher interest rates. 

And yet, households keep spending. In fact, we are even dipping into savings to do so. Historically, U.S. households devote about 8% of their income to savings. The current savings rate is half that. 

One likely explanation is that few households have access to an interest rate on their savings that exceeds the inflation rate. Households have been socialized to expect 8% and 9% inflation rates, and have probably not followed the news that inflation is typically now around 3% or lower, and for some time. 

In addition, while more sophisticated consumers can garner a 4% or a 5% interest rate on their savings, few households know or are willing to jump through the hoops to save at that rate. Bank balances have remained relatively high, but banks rarely offer more than a few tenths of a percent return on personal checking accounts. To park money at an interest rate less than the inflation rate means our savings are eroded by inflation faster than the interest rate can compound. 

Historically in our culture, people require an inducement of at least 3% or 4% over and above the inflation rate to be willing to save. If the inflation rate is 3%, then the minimum return on our savings must be in the order of 6% or 7%. Such risk-free returns are unknown in today’s economy. In fact, most households do not even earn the 3% return necessary to stay abreast of inflation, or the 5% or 6% return based on what many expect inflation is or may soon be.
Faced with the bleak prospect of inflation eating away at savings, many consumers see one choice - spend the money before inflation eats it away. 

In countries such as Argentina, which is currently suffering a 140% inflation rate, such immediate spending before prices rise is now ingrained into their culture. The resulting distortion to their preferred long run spending decisions wreaks economic damage. We may be suffering with some of that inflation expectation problem here too. It creates a bit of a vicious cycle, though. Higher than optimal spending increases aggregate demand and hence prices, and an unfortunate feedback loop results. Meanwhile, lower than optimal savings rates, when combined with the Fed’s policy of reducing liquidity, further increases interest rates. 

Some argue that higher wages have also enabled higher spending. Normally, if wage increases outstrip inflation, savings would rise as well. However, in almost no cases have wages kept pace with inflation. We have discussed a wide variety of inflation measures in this blog. Recently, the most common measure, the “headline” Consumer Price Index, overly represented the large bump in rents once landlords were legally allowed post-COVID to raise rents or evict tardy tenants. The Federal Reserve prefers to focus on the change in prices in the Personal Consumption Expenditure Survey. This measure is more reflective of economy-wide costs since it includes the true cost of our medical coverage, even if most of which those with good medical plans do not pay, beyond a modest co-pay. 

I find the most accurate measure is the Personal Consumption Expenditure Survey, with the volatile changes from Food and Energy removed. This measure shows a 15% price rise when compared to the level of prices just before COVID hit. Meanwhile, the headline inflation rate is at the upper bound of price measures, at 21%. All other measures are between these extremes, and all exceed the wage increases most people have received over the past three years. One would have had to receive 6% wage increases every year just to keep pace with these measures of inflation. Since this is unlikely to happen, wage- and salary-earning households appear destined to take a permanent hit on our real income.

Some sectors of the economy have experienced strong wage growth. They are typically in the service sector, and on the low wage end. This population is most vulnerable to inflation because they are more likely to rent, and food and energy costs make up a larger share of their spending. 

Middle income households who nonetheless live paycheck to paycheck are well behind in spending power as inflation has exceeded their wage increases. Those in higher income brackets spend a smaller fraction of their income on consumption, and hence can still garner an increase in savings even if their wages have not kept pace. 

These price increases will be difficult to reverse. Only if wage increases outpace inflation by the same magnitude and duration as inflation exceeded the pace of rising wages will consumers be indemnified. Such wage increases as inflation abates are unlikely. 

Nor will prices come down. Such deflations are incredibly rare and are economically dangerous. Unlike the present circumstance, deflations actually discourage spending and growth as people reason it is better to wait six months and then purchase when prices come down. 

Finally, as wages increase, if tax or social assistance brackets aren’t revised upward at the same rate, households find themselves paying more taxes or receiving benefits reductions. Municipal and school taxes are particularly insidious. Housing prices have risen dramatically over the past few years. A 30% increase in assessments without a commensurate 30% reduction in the tax rate actually means that we are paying significantly higher local and school taxes. Gloating politicians that claim they’ve done us a solid by “holding firm on the tax rate” or even by a modest mill rate reduction are still laughing all the way to the bank. Those improved local government balances result in new vehicle fleets, higher civil service wages, and ambitious road-building as windfall tax revenues burn a hole in political pockets. 

In the end, we are spending more to hedge against higher prices later, and we are paying more in taxes and everything else. These effects conspire to push the U.S. savings rate to 3.4% in September. This is the lowest in post WWII history but for a brief couple of years of excess just before the Great Recession of 2008. 

The Fed has some reckoning to do. As readers from this blog know, the Fed delayed economic intervention a little over a year ago as prices started cranking up right in the middle of the silly season when the Fed chairmanship was being negotiated. They then cranked up interest rates at a historically rapid rate as catchup for their belated policies. That caused inflation to persist and consumers to be befuddled. 

The good news is that the inflation rate by almost all measures is below 3%, and my personal favorite, the Personal Consumption Expenditure Survey less Food and Energy, is at an annualized rate of 1.8% based on data from the last few months. With a nominal interest rate on 10-year U.S. Treasuries hovering around 5%, we are finally at both a sweet spot of 2% inflation and a 3% real (inflation-adjusted) interest rate. 

Yet, people are saving too little, the unemployment rate is far lower than the Fed expects it should be after a year of tight monetary policy, and growth is three or four percentage points higher than what the Fed would like to rid us of our inflation expectation. The Fed is relying on other built-in headwinds to slow down this torrid economic pace, but the economy seems to be just too robust. The Fed is doing what our parents used to say - “don’t make me come over there…” We are giving them little choice and putting them into that Faustian region where they fear they may need to induce sterner medicine and then have to mop things up as businesses and banks are inadvertently caught in the crossfire. 

Meanwhile, government has overspent last year more than they overspent from 1776 to 1986 combined, and have run up a total debt that is four times higher than it was in 2006. Government mostly issues debt with maturities well less than ten years, which means that about 40% of that debt first issued when the 10-year Treasury rate was held artificially to around 1% must be reissued in the next few years at rates three or four times higher. I expect we will see debt service approach a trillion dollars per year soon. This will represent the largest single component of the discretionary budget funded from the general fund. We can talk all we want about trimming spending on social programs or defense, but we have absolutely no power to trim interest on our debt that arose from profligate spending over the past two presidencies. 

It is just amazing just how normal some economic variables are while others are completely out of whack. This is truly unchartered territory. Bond traders are worried sick, but most people remain blissfully unaware.