How long can Consumers Keep Carrying the Economy?
Consumer spending accounts for about two-thirds of U.S. gross domestic product (GDP), so it plays an outsized role in driving economic growth or slowing it down.1 For the last 18 months, U.S. consumers have kept the economy strong despite high inflation and rising interest rates. There is much discussion as to whether consumer spending will continue into 2024.
The Federal Reserve recently did not adjust interest rates. Raising interest rates has the same impact as increasing consumer spending. Both the level of consumer spending and increased interest rates help combat inflation. The Fed’s actions regarding interest rates try to balance numerous factors including consumer spending and employment. A reversal of spending and interest rates could lead to a recession
Measuring spending and inflation
The standard measure of consumer spending is personal consumption expenditures (PCE), released each month by the Bureau of Economic Analysis (BEA). Economists look at the monthly change in PCE for the short-term trend and the year-over-year change for the longer-term trend.
September PCE increased 0.7% over August, a strong monthly growth rate and up from 0.4% in August over July. The September increase was 0.4% measured in “real” inflation-adjusted dollars, which indicates that consumers were spending more than the rate of inflation. The annual change in PCE was 5.9%, well above the 3.4% annual change in the PCE price index, which is the Fed’s preferred measure of inflation. (The Fed’s target for PCE inflation is 2%.)2–3
The pandemic effect
The current consumer spending story began with the pandemic recession, when a broad range of business activity stopped, and consumers received large government stimulus packages with little to spend it on. In April 2020, the personal saving rate — the percentage of personal income that remains after taxes and spending — spiked to a record 32%, almost double the previous high. It declined as businesses reopened but remained above pre-pandemic levels until late 2021, when stimulus had ended, and high inflation made spending more expensive. The September 2023 saving rate was just 3.4%, well below the 6.5% average before the pandemic.4 While a low saving rate could be cause for concern in the long term, it indicates that consumers are willing to spend their income despite higher prices.
Why are consumers spending instead of saving?
Multiple explanations have been offered for this high-spending/low-saving pattern. Some lower-income consumers may be spending a larger percentage of their income because they must — they are spending more for basic needs due to high inflation. People with more disposable income might still be responding to pent-up demand for goods and services that were not available during the pandemic. And, after the tragedies and disruptions of the pandemic, some consumers may prefer to spend now and worry less about the future. The expensive housing market could be adding to this trend by making a typical saving goal seem unattainable to younger consumers.5
On a macro level, however, consumers may be spending instead of saving because they still have substantial savings. Although it was thought that pandemic-era savings were nearly exhausted, revised government data suggests there may be $1 trillion to $1.8 trillion in so-called “excess savings” still available. About half of this is likely held by households in the top 10% income bracket, but that still leaves a large savings buffer that could continue to drive middle-class spending for some time.6
The recently released Federal Reserve Survey of Consumer Finances revealed a similar story. The average inflation-adjusted median net worth of American families jumped by a record 37% from 2019 to 2022 — more than double the previous highest increase in the Fed survey, which is released every three years. Every demographic group saw substantial increases, but the largest by far was for consumers under age 35, whose net worth increased 143%. Because this survey only went through 2022, it does not capture the effects of continuing inflation in 2023.7
Wages and inflation
While pandemic-era savings may support consumer spending well into 2024, only wages can maintain strong spending for the long term. The question is whether wages will keep up with inflation without rising so quickly that they drive inflation even higher. For the 12-month period ending September 2023, average hourly earnings increased 4.2%. This was above the 3.4% PCE inflation rate over the same period, but down from the 5.1% pace of wage increases a year earlier.8 The fact that wage growth is keeping up with inflation while also slowing down bodes well for the goal of taming inflation with continued consumer spending.
Holiday spending
The winter holiday season, officially defined as November and December, accounts for about 20% of retail spending for the year, and is even more important for some retailers. An annual survey by the National Retail Federation found that consumers plan to spend an average of $875 this year on gifts, decorations, holiday meals, and other seasonal items. This is up from $833 in 2022 and slightly above the five-year average.9 Two broader surveys have found declines in consumer confidence in recent months, but it remains to be seen whether this leads to a decline in spending.10-11 While the winter holidays are not a “make or break” situation for the U.S. economy, this year’s holiday spending may provide clues to consumer behavior in the new year.
1–2, 4) U.S. Bureau of Economic Analysis, 2023
3, 7) Federal Reserve, 2023
5) The Wall Street Journal, October 1, 2023
6) Bloomberg, October 10, 2023
8) U.S. Bureau of Labor Statistics, 2023
9) National Retail Federation, 2023
10) The Conference Board, September 26, 2023
11) University of Michigan, October 27, 2023
Rising Oil Prices Could Be a Threat to the Economy
Oil prices have increased more than 30% since late June, driving up transportation costs for consumers and businesses and putting financial markets on edge. West Texas Intermediate crude, the U.S. benchmark for oil prices, was $93 per barre September 27, the highest level since August 2022. Brent crude (the global oil benchmark) rose above $96.1
Gasoline prices have followed suit. On September 27, the national average price for a gallon of unleaded gas was $3.83, up from $3.75 a year earlier. The price in California, the most expensive state for gasoline, averaged $5.89 per gallon.2
Market dynamics have impacted fuel prices in recent months. This adds concerns about broader inflation and the nation’s economic prospects.
Tight oil supplies
Oil prices are sensitive to shifts in the delicate balance between supply and demand in the global market. Much of the third quarter’s increase has been attributed to a combination of record-high global demand and coordinated supply cuts.3 On September 5, Saudi Arabia and Russia announced the extension of voluntary production cuts (1.3 million barrels per day combined) through the end of 2023. These cuts, which began in June, are on top of cuts that were previously put in place through 2024 by the Organization of the Petroleum Exporting Countries (OPEC), along with Russia and other allied oil producers (dubbed OPEC+). In total, supply cuts are expected to reduce global crude inventories by 3.3 million barrels per day in Q4 2023.4
OPEC is a coalition of 13 member countries, led by Saudi Arabia, which regulate their output to support oil prices. OPEC joined forces with the 10 OPEC+ countries in 2016 so they would have more power to influence prices. The two groups produced about 59% of the world’s supply of crude in 2022.5
Even so, OPEC does not have the iron grip on the oil market that it once wielded. Due to advances in shale drilling methods, U.S. oil production has more than doubled since 2011. The United States has been the top oil-producing nation since 2018 and was responsible for 20% of the world’s total in 2022. Saudi Arabia and Russia followed behind with 12% and 11%, respectively.6
Pain at the pump
Crude accounted for 57% of the nationwide cost of a gallon of gas in 2022, with the remainder reflecting refining costs, marketing and distribution, and taxes. Moreover, market conditions and gas prices vary widely by state and region.7
Gas prices also respond to seasonal demand shifts. For example, they tend to climb in the summer, when more drivers hit the road for vacations, then decline in the fall. In addition to the rising cost of crude, extreme heat in 2023 forced refineries in the Southeast to operate below capacity for safety reasons, pushing up prices even more than would be typical in the summer.8
On the bright side, the national average gas price is still below the record of $5.02 set in June 2022, when global oil costs spiked in the months following Russia’s invasion of Ukraine. And most states switch to a cheaper winter blend by October, which could deliver some price relief.9
Will U.S. drilling fill the gap?
Gasoline and heating oil (both derived from crude) are essential expenses for many households, which may leave them with less money to spend on other goods and services. A broad pullback in consumer spending — which accounts for about two-thirds of U.S. gross domestic product (GDP) — could take a significant toll on growth.10
Extended periods of high oil prices have been blamed for bringing on recessions in the past, and low prices have sometimes provided an economic boost. But this relationship has become more complex as the United States has expanded its presence in the global oil market. The United States has been called a swing producer because production levels often fluctuate in response to market prices. High oil prices tend to benefit producers by pumping up company profits, and they incentivize more hiring and drilling. A surge in drilling could have a positive impact on GDP that offsets some of the negative forces.
But more U.S. production is not guaranteed. With oil prices sitting above $100 per barrel for much of 2022, companies were reluctant to invest in drilling.11 In recent weeks, U.S. producers have reportedly added drilling rigs in the shale oil patch at the fastest rate since November of 2022, but it’s still unknown whether U.S. production will increase enough to lower prices.12
Inflation and the Fed
When fuel costs are high, businesses must decide whether to absorb them — lowering profit margins — or pass them on to consumers, which could reignite inflation across the economy.
Measured by the consumer price index (CPI), inflation increased 0.6% in August and was up 3.7% over the previous year. A 10.6% surge in gasoline prices was responsible for more than half of that monthly increase.13
The Federal Reserve has been raising interest rates aggressively to control inflation by slowing economic activity. Despite the rate hikes, the economy has remained surprisingly strong, so higher fuel costs may help the Fed’s efforts to slow the pace. Even so, the inflationary effects associated with rising oil prices appear to be another risk to the economic outlook that Fed policymakers must consider as they decide the future path of interest rates.
1) The Wall Street Journal, September 27, 2023
2, 9) American Automobile Association, 2023
3, 12) The Wall Street Journal, September 19, 2023
4) Bloomberg, September 12, 2023
5–7) U.S. Energy Information Administration, 2023
8) Associated Press, August 2, 2023
10) U.S. Bureau of Economic Analysis, 2023
11) The Wall Street Journal, February 24, 2022
13) U.S. Bureau of Labor Statistics, 2023
What Happens if There is a Government Shutdown?
There are only a few days till the U.S. government may shutdown. It is possible that a last-minute agreement could avoid a shutdown. Following is an abbreviated summary of the federal funding process, the current situation in Congress, and the potential consequences of a failure to fund government operations.
Twelve appropriations bills
The federal fiscal year begins on October 1, and under normal procedures 12 appropriations bills for various government sectors should be passed by that date to fund activities ranging from defense and national park operations to food safety and salaries for federal employees.
These appropriations are considered discretionary spending, meaning that Congress has flexibility in setting the amounts. Although discretionary spending is an ongoing source of conflict, it accounted for only 27% of federal spending in FY 2023, and almost half of that was for defense, which is typically less of a point of conflict. Mandatory spending (including Social Security and Medicare), which is required by law, accounted for about 63%, and interest on the federal debt accounted for 10%.1
It is obvious that it would be helpful for federal agencies to know their operating budgets in advance of the fiscal year, but all 12 appropriations bills have not been passed before October 1 since FY 1997. In 11 of the last 13 years, lawmakers have not passed a single spending bill in time.2 That is the situation as of September 27 this year. (One bill, to fund military construction and the Department of Veterans Affairs, has been passed by the House but not the Senate.)3
Continuing resolutions and omnibus spending bills
To delay further budget negotiations, Congress typically passes a continuing resolution, which extends federal spending to a specific date, generally at or based on the same level as the previous year. These bills are essentially placeholders that keep the government open until full-year spending legislation is enacted. Since 1998, it has taken an average of almost four months after the beginning of the fiscal year for that year’s final spending bill to become law.4
Even with the extension provided by continuing resolutions, Congress seldom passes the 12 appropriations bills. Instead, they are often combined into massive omnibus spending bills that may include other provisions that do not affect funding. For example, the SECURE 2.0 Act, which fundamentally changed the retirement savings rules, was included in the omnibus spending bill for FY 2023, passed in late December 2023, almost three months into the fiscal year.
Current Congressional situation
The U.S. Constitution gives the House of Representatives sole power to initiate revenue bills, so the House typically passes funding legislation and sends it to the Senate. There are often conflicts between the two bodies, especially when they are controlled by different parties, as they are now. These conflicts are typically settled through negotiations after a continuing resolution extends the budget process.
The Senate acted first this year, releasing bipartisan legislation on September 26 that would maintain current funding through November 17 and provide additional funding for disaster relief and the war in Ukraine. Although this is likely to pass the Senate later in the week, it was unclear how the House would react to the legislation.5
Late on September 26, the House cleared four appropriation bills for debate (Agriculture, Defense, Homeland Security, and State Department). It is unknown whether these bills will pass the House, and if they do, it will be too late to negotiate the provisions with the Senate. A proposed continuing resolution that would extend government funding and include new provisions for border security had not been cleared for debate as of the afternoon of September 27.6
Effects of a shutdown
The effects of a government shutdown depend on its length, and fortunately, most are short. There have been 20 shutdowns since the current budget process began in the mid-1970s, with an average length of eight days. The longest by far was the most recent shutdown, which lasted 35 days in December 2018 and January 2019, and demonstrates some potential consequences of an extended closure.7 However, in 2018-19, five of the 12 spending bills had already passed before the shutdown — including large agencies like Defense, Education, and Health & Human Services — which helped limit the damage. The current impasse, with no appropriations passed, could lead to an even more painful situation.8
Some things will not be affected: The mail will be delivered. Social Security checks will be mailed. Interest on U.S. Treasury bonds will be paid.9 However, some programs will stop immediately, including the Supplemental Nutrition Program for Women, Infants, and Children, which helps to provide food for about 7 million low-income mothers and children.10
Federal workers will not be paid. Workers considered “essential” will be required to work without pay, while others will be furloughed. Lost wages will be reimbursed after funding is approved, but this does not help lower-paid employees who may be living paycheck to paycheck.11 In an extended shutdown, the greatest hardship would fall on lower-paid essential workers, which would include many military families. Furloughed workers would struggle as well, but they might look for other jobs, and in many states would be able to apply for unemployment benefits.12 (Members of Congress, who are paid out of a permanent appropriation that does need renewal, would continue to be paid.)13
Air travel could be affected. In 2019, absenteeism more than tripled among Transportation Security Administration (TSA) workers, resulting in long lines, delays, and gate closures at some airports. According to the TSA, many workers took time off for financial reasons.14 Air traffic controllers, who are better paid, remained on the job without pay and without normal support staff. However, on January 25, 2019, an increase in absences by controllers temporarily shut down New York’s La Guardia airport and led to substantial delays at airports in Newark, Philadelphia, and Atlanta. This may have been an impetus to reopen the government later that day.15
Unlike federal employees, workers for government contractors are not guaranteed to be paid, and contractors often work side-by-side with federal employees in government agencies. In 2019, it was estimated that 1.2 million contract employees faced lost or delayed revenue of more than $200 million per day.16 A more widespread shutdown would put even more workers at risk.
While essential workers will maintain some federal services, furloughed workers would leave significant gaps. At this time, it’s unknown exactly how each agency will respond to a shutdown. In 2019, some national parks used alternate funding to maintain limited access, which caused problems with trash and vandalism and was deemed illegal by the Government Accounting Office. This year, all parks might be closed during an extended shutdown.17 Many other federal services may be delayed or suspended, ranging from food inspections to small business loans and economic reports.18 Delays in economic statistics could make it more difficult for the Federal Reserve to judge appropriate policy.19
Although a shutdown would cause temporary hardship for workers and the citizens they serve, the long-term effect on the economy would be relatively benign, because lost payments are generally made up after spending is authorized. A shutdown might decrease gross domestic product (GDP) for the fourth quarter of 2023, but if the shutdown ends by the end of the year, GDP for the first quarter of 2024 would theoretically be increased. Even if delayed spending is recovered, however, lost productivity by furloughed workers will not be regained. And an extended shutdown could harm consumer and investor sentiment.20
Surprisingly, previous shutdowns generally have not hurt the broad stock market, other than short-term reactions. But the current market situation is delicate to begin with, and it is impossible to predict future market direction.21
For now, it’s wise to maintain a steady course in your own finances. In the event of a shutdown, be sure to check the status of federal agencies and services that may affect you directly.
All investments are subject to market fluctuation, risk, and loss of principal. When sold, investments may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. Projections are based on current conditions, subject to change, and may not happen.
1) Congressional Budget Office, May 2023
2, 4, 8) Pew Research Center, September 13, 2023
3) Committee for a Responsible Federal Budget, September 27, 2023
5, 6, 9, 18, 19) The Wall Street Journal, September 26, 2023
7, 11) CNN, September 21, 2023
10) MarketWatch, September 26, 2023
12) afge.org, September 25, 2023 (American Federation of Government Employees)
13) CBS News, September 25, 2023
14) Associated Press, January 21, 2019
15) The Washington Post, January 25, 2019
16) Bloomberg, January 17, 2019
17) Bloomberg Government, September 12, 2023
20) Congressional Research Service, September 22, 2023
21) USA Today, September 26, 2023
Congress Tells Treasury to Expect SECURE 2.0 Technical Fixes
Congress sent a letter to U.S. Treasury Secretary Janet Yellen and IRS Commissioner Daniel Werfel late in May, that it will introduce legislation to correct several technical errors in the SECURE 2.0 Act. The letter, signed by Senators Ron Wyden (D-OR) and Mike Crapo (R-ID), chair and ranking member of the Senate Finance Committee, respectively, and Representatives Jason Smith (R-MO) and Richard Neal (D-MA), chair and ranking member of the House Ways and Means Committee, respectively, describes four provisions in SECURE 2.0 with problematic language.
- Startup tax credit for small employers adopting new retirement plans.
- Change in the required minimum distribution (RMD) age from 73 to 75.
- SIMPLE IRA and SEP plan Roth Accounts
- Requirement that catch-up contributions be made on a Roth basis for high earners.
Startup tax credits for small employers
Section 102 of SECURE 2.0 provides for two tax-credit enhancements for small businesses who adopt new retirement plans, beginning in 2023.
First, for employers with 50 employees or fewer, the pension plan startup tax credit increases from 50% of qualified startup costs to 100%, with a maximum allowable credit of $5,000 per year for the first three years the plan is in effect.
Second, the Act offers a new tax credit for employer contributions to employee accounts for the first five tax years of the plan’s existence. The amount of the credit is a maximum of $1,000 for each participant earning not more than $100,000 in income (adjusted for inflation). Each year, a specific percentage applies, decreasing from 100% to 25%. The credit is reduced for employers with 51 to 100 employees; no credit is available for those with more than 100 employees.
The letter notes, “The provision could be read to subject the additional credit for employer contributions to the dollar limit that otherwise applies to the startup credit. However, Congress intended the new credit for employer contributions to be in addition to the startup credit otherwise available to the employer.”
Change in RMD age.
Numerous comments noted that a technical correction is needed for Section 107 of the Act, which raised the RMD age from 72 to 73 beginning this year, and then again to 75 in 2033. The intention was to increase the age to 73 for those who reach age 72 after December 31, 2022, and to 75 for those who reach age 73 after December 31, 2032. However, the provision could be misinterpreted to mean the age-75 rule applies to those who reach age 74 after December 31, 2032.
SIMPLE IRA and SEP Roth accounts
Section 601 of the Act permits SIMPLE IRAs and Simplified Employee Pension plans to include a Roth IRA. The provision could have been interpreted that the provision was meant that SEP and SIMPLE IRA contributions must be included when determining annual Roth IRA contribution limits. As the letter explains, “Congress intended that no contributions to a SIMPLE IRA or SEP plan (including Roth contributions) be taken into account for purposes of the otherwise applicable Roth IRA contribution limit.”
Roth catch-up contributions for high earners
Addressing what the American Retirement Association called a “significant technical error” in Section 603, the letter clarified a rule surrounding catch-up contributions for high earners. Specifically, the rule’s intent was to require catch-up contributions for those earning more than $145,000 to be made on an after-tax, Roth basis beginning in 2024; however, language in a “conforming change” detailed in the provision could be interpreted to effectively eliminate the ability for all participants to make any catch-up contributions.
The congresspeople’s letter clarified that, “Congress did not intend to disallow catch-up contributions nor to modify how the catch-up contribution rules apply to employees who participate in plans of unrelated employers. Rather, Congress’s intent was to require catch-up contributions for participants whose wages from the employer sponsoring the plan exceeded $145,000 for the preceding year to be made on a Roth basis and to permit other participants to make catch-up contributions on either a pre-tax or Roth basis.”
No time frame given.
Although the letter provided no specific period for introducing the corrective legislation, it did indicate that such legislation may also include additional items. Stay tuned.
Have You Been Following the Debt Ceiling Debate?
President Joe Biden and House Speaker Kevin McCarthy met on May 22 to discuss raising the statutory limit on U.S. government debt, generally called the debt ceiling. There was not resolution although both termed the discussion “productive,”, and their respective negotiating teams continued discussions.1 Here are some answers to questions you may have about the issues behind the current impasse.
What is the debt ceiling? The debt ceiling is a statutory limit on cumulative U.S. government debt, which is the sum of annual deficits since 1835 — the only time the U.S. government had no debt — plus interest owed to investors who purchased Treasury securities issued to finance the debt.2 It limits the amount that the government can borrow to meet financial obligations already authorized by Congress. It does not authorize future spending. However, raising the debt ceiling has been used in recent years as leverage to negotiate on the federal budget.
Why do we have a debt ceiling? A debt ceiling was first introduced in 1917 to make it easier for the federal government to borrow during World War I. Before that time, all borrowing had to be authorized by Congress in extremely specific terms, which made it difficult to respond to changing needs. The modern debt ceiling, which aggregates almost all federal debt under one limit, was established in 1939 and has generally been used as a flexible structure to encourage fiscal responsibility.3 Since 1960, the ceiling has been raised, modified, or suspended 78 times, mostly with little fanfare until a political battle in 2011.4
How much is the debt ceiling? The current limit was set by Congress at about $31.4 trillion in December 2021.5 The debt was less than $6 trillion in 2001, when it began to rise due to tax cuts and increased military and national security spending in response to 9/11. It has tripled since 2008, driven by reduced tax revenues and stimulus spending during the Great Recession and the COVID-19 pandemic.6
When will we reach the debt ceiling? The government reached the $31.4 trillion limit on January 19, 2023. Since then, the Treasury has been using short-term accounting tactics (called “extraordinary measures”) to allow spending for a limited period without raising the ceiling.7 According to Treasury Secretary Janet Yellen, this extension is expected to expire on or shortly after June 1, 2023.8 The so-called “X-date” could vary because tax revenues are not fully predictable. It has come more quickly than anticipated, due to postponement of the tax-filing deadline for disaster-area taxpayers in certain states and lower capital gains tax receipts.9
What will happen if the ceiling is not increased? The U.S. government will not be able to pay all its financial obligations. This has never happened, so it is difficult to predict exactly how it would play out. The Treasury could still pay some of its obligations from incoming revenues, but there would have to be choices regarding what bills would not be paid. These are some of the possible results.
- The government could default on its bond payments. U.S. Treasury securities are generally considered among the safest investments in the world because they are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. These securities are widely held by individual and institutional investors as well as local, state, and foreign governments. Even the possibility of defaulting on interest payments could disrupt global markets, and an extended default could have serious economic repercussions around the world. An estimate by Moody’s Analytics suggests that a one-week default could send the U.S. economy into a mild recession with the loss of 1.5 million jobs and real GDP contraction of 0.7 percentage point. A default through the end of July (which seems highly unlikely) could cause a deep recession with 7.8 million lost jobs and a real GDP decline of 4.6%. Any default, or even near-default, could result in downgrading the U.S. credit rating, as occurred in 2011. This would make borrowing more expensive, adding to the ongoing problem.10
- Government payments could be delayed. Social Security and Veterans benefit payments could be delayed, causing hardship to those who depend on them for immediate needs. The same is true for wages of U.S. government workers, and overdue payments to government contractors could mean they may not be able to pay their employees. Late reimbursements to Medicare providers could strain smaller hospitals and medical practices. Any past due payments would be made once the debt ceiling is raised, but the short-term consequences could be painful.
What are the issues in the negotiations? Public statements from negotiators indicate the key issues include caps on future spending, use of unspent COVID-relief funds, work requirements for certain social programs, and expediting rules for energy projects. Both sides have agreed to spending caps in general terms, but they differ on how caps should be structured. The 2011 debt ceiling impasse resulted in spending caps, which had mixed results over the long term.11 Any caps would only affect discretionary spending, accounts for just 28% of federal spending. Defense spending is almost half of that amount. The rest is mandatory spending, including Social Security and Medicare (which will account for nearly 35% of federal spending in 2023) and interest on the national debt.12
Will there be a resolution? It is impossible to know for sure, but both sides have clearly stated that they will not allow the U.S. government to default on its obligations. However, time is growing short, and any agreement must pass in both the House and the Senate, requiring at least some bipartisan support. Speaker McCarthy has said that an agreement must be reached early enough to give House lawmakers a required 72-hour period to review the legislation before the June 1 deadline.13 If an agreement is not reached by that time, a temporary measure could suspend or raise the ceiling for a limited period to provide more time for negotiations.
Should investors worry? Although a default could have serious market repercussions, the most likely scenario is that the ceiling will be suspended or raised close to the deadline. If so, any related market volatility is likely to be temporary.14 While the U.S. debt is a significant issue, your investment strategy should be based on your long-term goals and risk tolerance, and it’s generally wise to stay the course through political conflicts.
The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. Forecasts are based on current conditions, are subject to change, and may not happen.
1, 11, 13) The New York Times, May 22, 2023
2, 4, 6, 8) U.S. Treasury, 2023
3) Bipartisan Policy Center, 2023
5, 7, 12) Congressional Budget Office, February 2023
9-10, 14) Moody’s Analytics, May 2023
Ceiling and Deficit Spending
The U.S. government reached its statutory limit, commonly called the debt ceiling, January 19,2023. The current limit was set by Congress at about $31.4 trillion in December 2021.1
Janet Yellen, Treasury Secretary, started well-established “extraordinary measures” to allow necessary borrowing for a limited period the same day. While Yellen projects the extension will last until early June, the Congressional Budget Office (CBO) estimates it may last until sometime between July and September. However, the CBO cautions that if April tax revenues fall short of its projections, the Treasury could run out of funds earlier.2–3
Flexibility vs. Fiscal Fights
A debt ceiling was first established in 1917 to give the federal government more flexibility to borrow during World War I. Previously, all borrowing had to be authorized by Congress in very specific terms, which made it difficult for the government to respond to changing needs.4
The modern debt ceiling, which aggregates almost all government debt under one limit, was established in 1939. Since 1960, it has been raised, modified, or suspended 78 times, mostly with little fanfare. That changed in 2011, when a political battle over the ceiling pushed the Treasury so close to the edge that Standard & Poor’s downgraded the credit rating of the U.S. government.5–6
The debt ceiling limits the amount that the U.S. Treasury can borrow to meet financial obligations already authorized by Congress. It does not authorize future spending. However, beginning with the bitter battle of 2011, it has been used as leverage for partisan negotiations over government spending. With the White House and the House of Representatives — which must authorize spending — held by different parties, this year’s negotiations could be particularly difficult.
Potential Consequences
If the debt ceiling is not raised in a timely manner, the U.S. government could default on its financial obligations, resulting in unpaid bills, higher interest rates, and a loss of faith in U.S. government securities that would reverberate throughout the global economy. While it’s unlikely that the current situation will lead to a default, pushing negotiations close to the edge can be damaging in itself. It was estimated that the 2011 impasse cost U.S. taxpayers $1.3 billion in increased borrowing costs in FY 2011 with additional costs in the following years.7
The Deficit and the Debt
The federal government runs at a deficit when tax revenues are not sufficient to meet spending obligations. Federal spending has outpaced revenue for the last 50 years, except from 1998 to 2001.8 Annual budget deficits add to the national debt.
The current debt of $31.4 trillion is the highest in U.S. history.9 Measuring the debt as a percentage of gross domestic product (GDP) is a better comparison over time. Economists look at debt held by the public — funds the government has borrowed to meet operational expenses and liabilities, primarily through issuing Treasury securities. Interagency debt — funds borrowed from government accounts such as the Social Security trust funds — is also subject to the limit but does not directly affect the economy or federal budget.
At the end of fiscal year 2022 (September 30, 2022), debt held by the public was equivalent to 97% of GDP. In 2019, before the pandemic, it was 79% of GDP, and in 2007, before the Great Recession, it was 35%. Both crises caused a significant increase of the deficit and debt due to lower tax revenues and high spending on government stimulus programs. The last time the debt exceeded current levels was at the end of World War II.10-11
A February 2023 analysis, the CBO projected that the debt will rise steadily over the next decade to 118% of GDP in 2033, which would be the highest percentage in U.S. history. The driving forces behind this increase would be higher spending on Social Security and Medicare, and rising interest costs (due to increasing debt and higher rates). If current laws remain unchanged, the debt is projected to rise even more quickly in the next two decades, reaching 195% of GDP in 2053.12
No Easy Answer
The only way to change this trajectory is to increase revenue, reduce spending, or both. The best scenario would be decades of high GDP growth that increases revenue at current tax rates, but this seems unlikely. The CBO projects real (inflation-adjusted) GDP growth to average a tepid 1.7% annually over the next decade.13 Raising tax rates may be necessary, but that is always a difficult political option.
There is little room to maneuver on the spending side. Only 28% of federal spending is “discretionary,” meaning Congress can set amounts through annual appropriations bills, and almost half of that spending goes to national defense, which few leaders would want to cut in the current global climate. The rest is mandatory spending, including Social Security and Medicare (which will account for nearly 36% of federal spending in 2023) and interest on the national debt.14 While both parties have indicated that Social Security and Medicare are off the table, other mandatory spending could be reduced through Congressional action.
The White House is expected to release its budget proposal for FY 2024 this month, followed by a counterproposal from House Republicans in April, setting up what is sure to be an intense period of budget negotiations. President Biden and House Speaker Kevin McCarthy have already begun to discuss the debt ceiling issue, and it remains to be seen whether the ceiling can be addressed outside of the budget process or whether it will be caught in the crosshairs. In either case, the ceiling will have to be raised or suspended in order to maintain U.S. government operations.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. Forecasts are based on current conditions, are subject to change, and may not come to pass.
1, 3, 10, 12–14) Congressional Budget Office, 2023
2, 6, 9) U.S. Treasury, 2023
4–5) Bipartisan Policy Center, 2023
7) U.S. Government Accountability Office, July 23, 2012
8, 11) U.S. Office of Management and Budget, 2023
Is the Yield Curve Signaling a Recession?
Long-term bonds generally provide higher yields than short-term bonds because investors demand higher returns to compensate for the risk of lending money over a longer period. Occasionally, however, this relationship flips, and investors are willing to accept lower yields in return for the relative safety of longer-term bonds. This is called a yield curve inversion because a graph showing bond yields in relation to maturity is essentially turned upside down (see chart).
A yield curve could apply to any bonds that carry similar risk, but the most studied curve is for U.S. Treasury securities, and the most common focal point is the relationship between the two-year and 10-year Treasury notes. The two-year yield has been higher than the 10-year yield since July 2022, and beginning in late November, the difference has been at levels not seen since 1981. The biggest separation in 2022 came on December 7, when the two-year was 4.26% and the 10-year was 3.42%, a difference of 0.84%. Other short-term Treasuries have also offered higher yields; the highest yields in early 2023 were for the six-month and one-year Treasury bills.1 (Although Treasuries are often referred to as bonds, maturities up to one year are bills, while maturities of two to 10 years are notes. Only 20- and 30-year Treasuries are officially called bonds.)
Predicting Recessions
An inversion of the two-year and 10-year Treasury notes has preceded each recession over the past 50 years, reliably predicting a recession within the next one to two years.2 A 2018 Federal Reserve study suggested that an inversion of the three-month and 10-year Treasuries may be an even more reliable indicator, predicting a recession within about 12 months.3 The three-month and 10-year Treasuries have been inverted since late October, and in December and early January the difference was often greater than the inversion of the two- and 10-year notes.4
Weakness or Inflation Control?
Yield curve inversions do not cause a recession; rather they indicate a shift in investor sentiment that may reflect underlying economic weakness. A normal yield curve suggests that investors believe the economy will continue to grow, and that interest rates are likely to rise with the growth. In this scenario, an investor typically would want a premium to tie up capital in long-term bonds and potentially miss out on other opportunities in the future.
Conversely, an inversion suggests that investors see economic challenges that are likely to push interest rates down and typically would rather invest in longer-term bonds at today’s yields. This increases demand for long-term bonds, driving prices up and yields down. (Bond prices and yields move in opposite directions; the more you pay for a bond that pays a given coupon interest rate, the lower the yield will be.)
The current situation is not so simple. The Federal Reserve has rapidly raised the benchmark federal funds rate to combat inflation, increasing it from near 0% in March 2022 to 4.25%–4.50% in December. As the rate for overnight loans within the Federal Reserve System, the funds rate directly affects other short-term rates, which is why yields on short-term Treasuries have increased so rapidly. The fact that 10-year Treasuries have lagged the increase in the funds rate may indeed mean that investors believe a recession is coming. But it could also reflect confidence that the Fed is winning the battle against inflation and will lower rates over the next few years. This is in line with the Fed’s projections, which see the funds rate peaking at 5.0%–5.25% by the end of 2023, and then dropping to 4.0%–4.25% in 2024 and 3.0%–3.25% in 2025.5
Inflation slowed somewhat in October and November, but there is a long way to go to reach the Fed’s target of 2% inflation for a healthy economy.6 The fundamental question remains the same as it has been since the Fed launched its aggressive rate increases: Will it require a recession to control inflation, or can it be controlled without shifting the economy into reverse?
Other Indicators and Forecasts
The yield curve is one of many indicators that economists consider when making economic projections. Among the most closely watched are the 10 leading economic indicators published by the Conference Board, with data on employment, interest rates, manufacturing, stock prices, housing, and consumer sentiment. The Leading Economic Index, which includes all 10 indicators, fell for nine consecutive months through November 2022, and Conference Board economists predict a recession beginning around the end of 2022 and lasting until mid-2023.7 Recessions are not officially declared by the National Bureau of Economic Research until they are underway, and the Conference Board view would suggest the United States may already be in a recession.
In The Wall Street Journal’s October 2022 Economic Forecasting Survey, most economists believed the United States would enter a recession within the next 12 months, with an average expectation of a relatively mild 8-month downturn.8 More recent surveys of economists for the Securities Industry and Financial Markets Association and Wolters Kluwer Blue Chip Economic Indicators also found a consensus for a mild recession in 2023.9–10
For now, the economy appears fairly strong despite high inflation, with a low November unemployment rate of 3.7% and an estimated 3.8% Q4 growth rate for real gross domestic product.11–12 Unfortunately, the indicators and surveys discussed above suggest an economic downturn in the next year or so. This would probably cause some job losses and other temporary financial hardship, but a brief recession may be the necessary price to tame inflation and put the U.S. economy on a more stable track for future growth.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. Forecasts are based on current conditions, are subject to change, and may not happen.
1, 4) U.S. Treasury, 2023
2) Financial Times, December 7, 2022
3) Federal Reserve Bank of San Francisco, August 27, 2018
5) Federal Reserve, 2022
6, 11) U.S. Bureau of Labor Statistics, 2022
7) The Conference Board, December 22, 2022
8)The Wall Street Journal, October 16, 2022
9) SIFMA, December 2022
10) USA Today, December 15, 2022
12) Federal Reserve Bank of Atlanta, January 5, 2023
What Does a Strong Dollar Mean for the U.S. Economy?
In late September 2022, the U.S. dollar hit a 20-year high in an index that measures its value against six major currencies: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona, and the Swiss franc. At the same time, a broader inflation-adjusted index that captures a basket of 26 foreign currencies reached its highest level since 1985. Both indexes eased slightly but remained near their highs in October.1–2
Intuitively, it might seem that a strong dollar is good for the U.S. economy, but the effects are mixed in the context of other domestic and global pressures.
World Standard
The U.S. dollar is the world’s reserve currency. About 40% of global financial transactions are executed in dollars, with or without U.S. involvement.3As such, foreign governments, global financial institutions, and multinational companies all hold dollars, providing a level of demand regardless of other forces.
Demand for the dollar tends to increase during difficult times as investors seek stability and security. Despite high inflation and recession predictions, the U.S. economy remains the strongest in the world.4 Other countries are battling inflation, too, and the strong dollar is making their battles more difficult. The United States recovered more quickly from the pandemic recession, putting it in a better position to weather inflationary pressures.
The Federal Reserve’s aggressive policy to combat inflation by raising interest rates has driven demand for the dollar even higher because of the appealing rates on dollar-denominated assets such as U.S. Treasury securities. Some other central banks have begun to raise rates as well — to fight inflation and offer better yields on their own securities. But the strength of the U.S. economy allows the Fed to push rates higher and faster, which is likely to maintain the dollar’s advantage for some time.
Exports and Imports
The strong dollar makes imported goods cheaper and exported goods more expensive. Cheaper imports are generally good for consumers and for companies that use foreign-manufactured supplies, but they can undercut domestic sales by U.S. producers.
At the same time, the strong dollar effectively raises prices for goods that U.S. companies sell in foreign markets, making it more difficult to compete and reducing the value of foreign purchases. For example, a U.S. company that sells 10,000 euros worth of goods to a foreign buyer would receive less revenue when a euro buys fewer dollars. Some experts are concerned that the strong dollar will dampen the post-pandemic rebound in U.S. manufacturing.5 More broadly, the ballooning trade deficit cuts into U.S. gross domestic product (GDP), which includes imports as a negative input and exports as a positive input.
Overseas Exposure
Generally, large multinational companies have the most exposure to risk from currency imbalances, and the stock market has shown signs of a shift from large companies — which have dominated the market since before the pandemic — to smaller companies that may be more nimble and less dependent on overseas sales. The S&P SmallCap 600 index has outperformed the S&P 500 index through late October; if the trend continues through the end of the year, it would be the first time since 2016 that small caps have eclipsed large caps.6 The S&P MidCap 400 index has done even better. In the current bear market, however, better performance means lower losses; all three indexes have had double-digit losses through October 2022.7
Global Pain
A weak currency can be a boon for a country by making its exports more competitive. But with the world economy weakening, other countries are not reaping those benefits, while paying more on debt and imported essentials such as food and fuel that are traded in dollars. The Fed is focused on domestic concerns, but it is effectively exporting inflation while trying to control it at home, and global economic pain could ultimately spread to the U.S. economy.8
Slowing the Dollar
In the near term, the Fed’s aggressive rate hikes may reduce domestic demand for foreign goods, reducing the trade deficit and weakening the dollar. The advance Q3 2022 GDP estimate showed the trade gap closing, but it’s unclear if the trend will last.9
In the longer term, as inflation eases in the United States, the Fed will likely take its foot off the gas pedal and ultimately bring rates down. This would allow other central banks to catch up if they choose to do so and would make foreign currencies and securities more appealing. Lower oil prices (denominated in dollars) and/or any reduction in world tensions — such as a slowdown in the Russia-Ukraine war — might also help reduce demand for dollars.
The dynamics of these factors are complex, and it may take time for any of them to unfold. In the meantime, the strong dollar is a sign of U.S. economic strength, and it would not be wise to place too much emphasis on it for long-term investment decisions. However, this could be a great time for an overseas vacation.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid.
All investments are subject to market volatility and loss of principal. Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, and economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost. The value of a foreign investment, measured in U.S. dollars, could decrease because of unfavorable changes in currency exchange rates.
The S&P 500 index is an unmanaged group of securities that is considered to be representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is not a guarantee of future results. Actual results will vary.
1) MarketWatch, October 19, 2022 (U.S. Dollar index)
2) Federal Reserve, 2022 (Real Broad Dollar index)
3, 8) The New York Times, September 26, 2022
4, 6) The Wall Street Journal, October 17, 2022
5) The Wall Street Journal, October 9, 2022
7) S&P Dow Jones Indices, 2022
9) U.S. Bureau of Economic Analysis, 2022
Are we in a Recession?
A common definition is that a recession occurs when there are two consecutive quarters of declining in gross domestic product (GDP). The GDP is the total of all the goods and services produced in a country. The National Bureau of Economic Research (NBER) determines when the United States (U.S.) is in a recession. It is a private nonpartisan organization that began dating business cycles in 1929. The committee, which was formed in 1978, includes eight economists who specialize in macroeconomic and business cycle research.1 The NBER defines a recession as “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” The committee looks at the big picture and makes exceptions as appropriate. For example, the economic decline of March and April 2020 was so extreme that it was declared a recession even though it lasted only two months.2
The committee studies a range of monthly economic data, with special emphasis on six indicators: personal income, consumer spending, wholesale-retail sales, industrial production, and two measures of employment. Because official data is typically reported with a delay of a month or two — and patterns may be clear only in hindsight — it generally takes some time before the committee can identify a peak or trough. Some short recessions (including the 2020 downturn) were over by the time they were officially announced.3
Public Opinion
Consumer sentiment is a significant factor. It is a powerful factor in consumer spending. Consumer spending is a substantial part of GDP. An early July poll, 58% of Americans said they thought the U.S. economy was in a recession, up from 53% in June and 48% in May.4 Yet many economic indicators, notably employment, remain strong. The current situation is unusual, and there is little consensus among economists as to whether a recession has begun or may be coming soon.5
GDP
Real (inflation-adjusted) GDP dropped at an annual rate of 1.6% in the first quarter of 2022 and by 0.9% in the second quarter.6
Since 1948, the U.S. economy has never experienced two consecutive quarters of negative GDP growth without a recession being declared. However, the current situation could be an exception, due to the strong employment market and some anomalies in the GDP data.7
Negative first-quarter GDP was largely due to a record U.S. trade deficit, as businesses and consumers bought more imported goods to satisfy demand. This was a sign of economic strength rather than weakness. Consumer spending and business investment — the two most important components of GDP — both increased for the quarter.8
Initial second-quarter GDP data showed a strong positive trade balance but slower growth in consumer spending, with an increase in spending on services and a decrease in spending on goods. The biggest negative factors were a slowdown in residential construction and a substantial cutback in growth of business inventories.9 Although inventory reductions can precede a recession, it’s too early to tell whether they signal trouble or are simply a return to more appropriate levels.10 Economists may not know whether the economy is contracting until there is additional monthly data.7
Employment
Economic data has been mixed recently. Consumer spending declined in May when adjusted for inflation, but bounced back in June.11 Retail sales were strong in June, but manufacturing output dropped for a second month.12 The strongest and most consistent data has been employment. The economy added 372,000 jobs in June, the third consecutive month of gains in that range. Total nonfarm employment is now just 0.3% below the pre-pandemic level, and private-sector employment is actually higher (offset by losses in government employment).13
The unemployment rate has been 3.6% for four straight months, essentially the same as before the pandemic (3.5%), which was the lowest rate since 1969.9 Initial unemployment claims ticked up slightly in mid-July but remained near historic lows.14 In the 12 recessions since World War II, the unemployment rate has always risen, with a median increase of 3.5 percentage points.16
With employment at such high levels, it may be questionable to characterize the current economic situation as a recession. However, the employment market could change, and recessions can be driven by fear as well as by fundamental economic weakness.
Inflation
The fear factor is inflation which ran at an annual rate of 9.1% in June, the highest since 1981.17 Wages have increased, but not enough to make up for the erosion of spending power, making many consumers more cautious despite the strong job market.18 If consumer spending slows significantly, a recession is certainly possible, even if it is not already under way. Inflation has forced the Federal Reserve to raise interest rates aggressively, with a 0.50% increase in the benchmark federal funds rate in May, followed by 0.75% increases in June and July.18 It takes time for the effect of higher rates to filter through the economy, and it remains to be seen whether there will be a “soft landing” or a more jarring stop that throws the economy into a recession.
Among the factors driving inflation are: Covid-19, Russian Invasion of Ukraine, supply chain disruptions, CARES ACTs 1, 2 and 3, fewer homes for sale than buyers, limited supply of semiconductors .
Unfortunately, no one knows the future, and economic forecasts vary significantly. Forecast range from remote chance of a recession to an imminent downturn with a moderate recession in 2023.19 If that turns out to be the case, or if a recession arrives sooner, it’s important to remember that recessions are generally short-lived, lasting an average of just 10 months since World War II. By contrast, economic expansions have lasted 64 months.20 To put it simply: The good times typically last longer than the bad.
Projections are based on current conditions, are subject to change, and may not happen.
1-3) National Bureau of Economic Research, 2021
4) Investor’s Business Daily, July 12, 2022
5) The Wall Street Journal, July 17, 2022
6) U.S. Bureau of Labor Statistics, 2022
7-8) MarketWatch, July 5, 2022
6,9,11,21) U.S. Bureau of Economic Analysis, 2022
10) The Wall Street Journal, July 28, 2022
12) Reuters, July 15, 2022
13–14, 17–18) U.S. Bureau of Labor Statistics, 2022
15) The Wall Street Journal, July 14, 2022
16) The Wall Street Journal, July 4, 2022
19) Federal Reserve, 2022
20) The New York Times, July 1, 2022
Good and Bad News about Social Security
With approximately 94% of American workers covered by Social Security and 65 million people currently receiving benefits, keeping Social Security healthy is a major concern.1 Social Security is financed primarily through payroll taxes. Unless Congress act benefits may eventually be reduced. Trustees of the Social Security Trust Funds release a detailed report to Congress in June. The good news was that the effects of the pandemic were not as significant as projected a year ago.
Mixed news for Social Security
Social Security program consists of two programs, the Old-Age and Survivors Insurance (OASI) program and Disability Insurance (OASDI). Each program has its own financial account (Trust Fund). Payroll taxes collected are deposited in the applicable Trust Fund. OASI provide benefits to retired workers, their families, and survivors of workers. D provides benefits to disabled workers and their families. Funding is also provided by other income (reimbursements from the General Fund of the U.S. Treasury and income tax revenue from benefit taxation).
Social security is required to invest funds collected in special government-guaranteed Treasury bonds that earn interest. These funds are now being used to pay benefits more than the payroll tax collected. Payroll taxes are not sufficient to pay current benefits. Changes in our demographics are a significant reason for the deficiency.
A recent report by the Trustees estimate that the funds will not be able to fund full retirement and survivor benefits. Benefit would then be reduced to 77% of scheduled OASI benefits, declining to 72% through 2096, the end of the 75-year, long-range projection period.
The Trustees report, estimate the combined reserves (OASDI) will be able to pay scheduled benefits until 2035. Benefit would then be reduced to 80% of scheduled benefits, declining to 74% by 2096. OASI and DI Trust Funds are separate, and generally one program’s taxes and reserves cannot be used to fund the other program. However, this could be changed by Congress, and combining these trust funds in the report is a way to illustrate the financial outlook for Social Security as a whole.
The above is based on current conditions and likely future demographic, economic, and program-specific conditions. Future events including the impact of the pandemic may results in changes not reflected in the Trustee’s estimates.
Some changes can be made to improve the situation
The Trustees continue to urge Congress to address the financial challenges. The sooner Congress acts the less harsh the changes will be. Some of the options that have been suggested including the following:
- Raising the current Social Security payroll tax rate. Increasing the payroll tax to 15.64% from 12.4% would correct the situation
- Raising or eliminating the ceiling on wages subject to Social Security payroll taxes ($147,000 in 2022).
- Raising the full retirement age from 67 (for anyone born in 1960 or later).
- Raising the early retirement age from 62.
- Reducing future benefits by about 20.3% for all current and future beneficiaries, or by about 24.1% if reductions were applied only to those who initially become eligible in 2022 or later.
- Changing the benefit formula that is used to calculate benefits.
- Calculating the annual cost-of-living adjustment (COLA) for benefits.
A comprehensive list of potential solutions can be found at https://www.ssa.gov/OACT/solvency/provisions/.
1) Social Security Administration, 2022
