September 08, 2023 | 14:20
The Right Balance (Sheet) for a Soft Landing?
The Right Balance (Sheet) for a Soft Landing?
One reason U.S. recession calls keep getting deferred—or even nixed—is the large number of buffers supporting demand, such as excess savings, revenge spending, and, more recently, real wage gains. But an underappreciated source of resilience is the generally healthy balance sheets of households and businesses.
To date, most households are having little trouble managing their debt in the face of rising credit costs. Of course, it helps that most people have a job, with the unemployment rate of 3.8% still close to half-century lows. But equally important is that total debt is low relative to income even after a prolonged period of depressed interest rates following the financial crisis. Although actual debt is at an all-time high, its ratio to disposable income (86%) is in line with the past-decade mean and well below the peak (116%) reached in 2008 (Chart 1). As a result, debt service costs remain below normal, with payments consuming less than a tenth of disposable income in Q1, still below pre-pandemic levels and the long-run mean (Chart 2). Less than 4% of income was spent on residential mortgage payments in the quarter, nearly two percentage points below normal. During the pandemic, many homeowners latched onto fixed-rate borrowing costs that were less than half current levels of around 7%. So, despite two-decade high rates, the effective mortgage interest rate paid by owners was just 3.9% in Q1, close to record lows and well below the long-run mean of over 5%.
Still, debt service costs on consumer loans have climbed back to long-run norms of 5.7% of disposable income as of Q1. Consequently, rising borrowing costs are starting to pressure household finances. While the 90-day-plus delinquency rate on all household loans remains low, it rose for a second straight quarter to 1.5% in Q2. The 30-day-plus rate for new delinquencies is 3.2%, still below pre-pandemic levels, but up in the past year amid some stress in auto loans and credit cards (Chart 3). Lower-income households are likely shouldering much of the pain, as the bottom-income quintile is the only group to see an outright decline in consumer loan balances in the past year to Q1.
Rising interest rates are sapping the appetite to borrow. Household debt rose just slightly in Q2 while lagging personal income growth for the first time in nearly two years. The slowing in credit balances marks a major downshift after soaring 8.5% in 2022 and 7.0% in 2021, the two largest annual increases since before the financial crisis (Chart 4). Residential mortgage balances even dipped in Q2 for the first time in several years. Monthly data show that consumer credit growth moderated to 5.8% y/y in June from above 7% a year ago. Auto loans decelerated to a 6.1% yearly rate last quarter after revving nearly 14% in 2021 when rebate cheques were flying out the door.
With debt growth slowing and asset values rising on rebounding equity and home prices, net worth hit a record high in Q2, eclipsing the prior peak set before the Fed started hiking rates.
Rising wealth incents spending, but excess savings could keep providing the wherewithal. There is a wide debate about how much extra cash households piled up during the pandemic and how much still exists today. Studies by the Federal Reserve and San Francisco Fed suggest this once large piggy bank has mostly been raided. In fact, households have drawn down earlier sizeable liquid assets in chequing and savings accounts and money market mutual funds (Chart 5). This suggests limited further support to spending, as noted in the Fed's latest Beige Book with some regions reporting that "consumers may have exhausted their savings and are relying more on borrowing to support spending."
Meantime, business finances are in reasonably good shape. Net worth is near all-time highs. Debt in relation to GDP is tracking long-term trends (Chart 6). As a share of assets, it is somewhat lower than before the pandemic and near the three-decade norm.
Business bankruptcy filings turned up in the first half of the year, but remain below pre-pandemic levels (Chart 7). At just 1.0% in Q2, delinquency rates on bank commercial and industrial loans are near record lows. The rate on commercial real estate loans is below 1%, though it has edged up and looks to rise further as hybrid work patterns shrink office demand.
Growth in business debt has slowed to less than a 5% y/y rate, below the two-decade norm. Aggravated by earlier stress in the regional banking sector, bank loans to commercial and industrial firms fell in the past six months to July. The downshift also reflects a year-long tightening of lending conditions, a sharp rise in borrowing costs, and the use of high cash balances to finance investments.
Businesses have material holdings of liquid assets. Deposits in chequing and savings accounts and money market funds are estimated at roughly $400 billion (or 8%) above the pre-pandemic trendline (adjusted for higher inflation) in Q2, equivalent to about 9% of annual fixed investment spending (Chart 8). And, unlike households, businesses haven’t really tapped deposits in the past year, providing an ample source of liquidity to build economic capacity.
Bottom Line: U.S. household and business finances are generally in good shape with little sign of widespread distress. Household finances appear sound, with manageable debt costs even at current high rates. However, the tailwind from excess savings may have passed. Business finances are generally strong with companies still holding substantial surplus deposits. Nonetheless, slowing credit growth and modestly rising default rates suggest that restrictive monetary policy is curbing demand. By providing just enough airflow to slow the plane’s descent but not enough thrust to prevent it from landing, the balance-sheet controls might be set just right for Captain Powell and crew to pull off a smooth landing.