Global Monthly - How hard are high rates hitting the economy?

Global View: High rates are clearly limiting growth, but strong balance sheets remain a buffer

“The pricing out of rate cuts is likely to run out of steam” was the prediction of our February Global Monthly, and indeed, markets are broadly unchanged in still expecting around 3-4 rate cuts by the ECB and Fed in 2024. Growth indicators offered further signs of a bottoming out in the eurozone and China, while in the US, the slowdown that started in January was confirmed by the February data. Big picture, the global economy is slowly converging towards a more trend-like pace of growth, and this remains our base case for the second half of 2024. This does not mean there aren’t things to worry about. As we explain in our China outlook, the recovery there is still too much tilted to the supply side, which – while helpful for global inflation – is stoking trade tensions. Indeed, the European Commission this month took the first step towards imposing tariffs on imports of electric cars from China, as it announced it had ‘sufficient evidence’ China has subsidised its exports. This raises the risk of a EU-China trade spat, even before a potential Trump 2.0 enters the fray. In the meantime, while markets appear more worried about inflation than growth risks at present, Fed Chair Powell last week reiterated that the risks to the outlook are ‘two-sided’ and that the Fed also worries that ‘if we ease too late, we could do unnecessary harm to employment’. Taking a cue from this, this month we take stock of the impact high rates have had so far on the economy.

Further bottoming out in eurozone & China; US slowdown confirmed

As we describe in our regional outlooks, growth indicators over the past month have pointed to a further stabilisation (or even modest recovery) in the eurozone and in China, while the US is now clearly slowing. In the eurozone specifically, the composite PMI rose for the fifth consecutive month, and is now on the cusp of signalling expansion in the eurozone economy at 49.9, having languished below 50 for most of the past year. The rise was driven again by services, which rose to a 9 month high of 51.1 in March. The manufacturing PMI fell back, but this was primarily due to a shortening in delivery times as the Red Sea disruptions unwound; indeed, if we remove the impact of this, the manufacturing PMI would have risen slightly thanks to stronger new orders (see chart above). All in all, the PMI is consistent with our base case for the eurozone, which sees GDP roughly stagnating in Q1, while the pickup in forward-looking expectations components suggests growth will pick up in Q2 (we have pencilled in 0.2% q/q for Q2).

Disinflation is also broadly continuing, although the US is seeing some ‘bumps in the road’ which we judge[A2] are unlikely to persist. We did raise our US PCE inflation forecast for this year by 0.4pp to 2.4% as oil prices – and refiner margins – picked up sooner than expected (in the eurozone, our inflation forecasts are unchanged as higher oil prices have been offset by lower natural gas prices). But as our latest oil market update describes, the modest growth outlook means our year-end forecast for oil prices is unchanged, and so therefore is our end 2024 inflation forecasts. Against this backdrop, while the Bank of Japan this month finally started to raise interest rates, the combination of normalising growth and inflation in the eurozone and US continues to point to a gradual lowering of interest rates by the ECB and Fed back to more normal levels from June onwards.

Where are we with monetary policy transmission?

In recent publications we have focused heavily on the inflation outlook, and how crucial wage growth and other inflation drivers are likely to be for the path of interest rates. However, the other key part of the equation is how much the high level of interest rates is weighing on growth, and specifically, the risk of recession that this poses. As inflation continues to normalise, growth considerations are likely to increasingly weigh in central bank decision-making going forward, and this was underlined last week by the aforementioned comments of Fed Chair Powell on the ‘two-sided’ risks to the outlook.

The growth risks of high rates was a theme we tackled repeatedly in the course of 2023. For much of last year, we expected recessions in advanced economies to result from the steepest rise in interest rates in decades – understandable, given that historically, this is the typical outcome of high rates. However, we also noted that households and business had very strong balance sheets after all of the government support (and restrained consumption and investment) of the pandemic period, and that this would limit the pain of high rates. Since then, the evidence has only mounted to support this thesis. As we describe below, high interest rates have clearly left their mark on the economy. But strong balance sheets have continued to be a more important buffer for growth than we had expected.

Taking stock of the high rates impact

The primary channel through which high rates affect the economy is by depressing lending to households and business. Higher rates make it more expensive to borrow, raising the interest burden on existing (floating rate) debt, and incentivising deleveraging vis-à-vis consumption and investment. Understandably, then, the most immediate and visible part of the economy to be hit by high rates was housing. Housing markets have corrected across advanced economies since mortgage rates started surging in late 2021, and housebuilding declined sharply. While housing markets have since rebounded – helped by falling mortgage rates in anticipation of central bank rate cuts – aggregate bank lending remains depressed, and is stagnating the eurozone and close to stagnation in the US. It is true that eurozone businesses are far more dependent on bank lending than in the US, where use of capital markets is more widespread. However, corporate bond issuance in the US has also slowed sharply, driven by outright declines in high yield issuance. Even with market rates having fallen in recent months, net issuance remains historically weak.

This weakness in lending has had an impact on growth. For instance, business investment in the eurozone has stagnated while in the US it is slowing. In the eurozone, the high savings rate appears also to have weighed on consumption. But such weakness in lending to the real economy would typically be associated with recession. Instead, while the eurozone has skirted recession, the economy has held up better than expected, while the US has been nowhere near close to recession. How did this happen, and will economies continue to dodge recession? We first tackle the ‘why’.

Looking at the charts on lending and bond issuance, what is striking is that just prior to the surge in interest rates, borrowing grew very sharply, as households and businesses took advantage of the very low rates in the pandemic. To some extent, this probably frontloaded some borrowing demand, and so some of this lending is likely funding activity in the current period.

A second and related factor is the strengthening of balance sheets, helped by massive government support – as well as restrained consumption and investment – during the pandemic and the energy crisis. This is evident in both debt ratios and cash buffers, particularly on the household side. Household debt in the eurozone fell to just 54.4% of GDP in Q3 23, the lowest since 2004, and in the US it fell to 62.6%, the lowest since at least 2003 (when the current comparable data series began). Corporate debt has not fallen quite as significantly, but in the US for instance it is the lowest since 2014, having been on a rising trend prior to the pandemic. Cash balances – both household and business – also remain historically high.

US households have been more willing to use their strong balance sheets…

The main reason for US economic outperformance over the past two years is arguably that it was largely unaffected by the energy crisis in Europe. The Inflation Reduction Act in the US is also sometimes cited, but the EU’s Recovery & Resilience Facility is probably having just as much of an impact in the eurozone (with for instance Italy currently outperforming on the back of this). A major driver, in our view, is behavioural. US households have been more willing to rely on their strong balance sheets to fund consumption than their eurozone counterparts. This is clear when looking at the household savings rate. While eurozone households have always tended to save more than those in the US, that gap has widened in recent years, with eurozone households saving even more than they normally do, while US households have been saving less than normal (see chart). Indeed, in the US, although household debt has been falling in the aggregate, credit card debt – particularly among low income households – has risen sharply, while high income households have continued to burn through the excess cash they saved during the pandemic.

…but this has not come without consequences

Although in the aggregate balance sheets remain healthy – and, if anything, continue to improve – in the US, there are signs of stress now resulting from high rates and the pockets of consumer exuberance. Interest expenses as a share of disposable income have risen to the highest since 2007, while the rate of those becoming overdue on their credit card debt is the highest since 2011 (see chart below). Because the aggregate debt picture is so benign, we do not think these problems pose a systemic risk to the economy. However, as increasing numbers of consumers become locked out of credit, this will inevitably weigh on consumption growth, and this is one of the main reasons we still expect some slowdown in the US economy over the coming quarters.

Central banks will probably be just in the nick of time to lower rates

Strong balance sheets have shielded many households and businesses from the pain of high rates, and with inflation normalising, those high rates are already starting to fall back. Indeed, the decline in bond yields as well as risk-on sentiment in equity markets has pushed financial conditions in the eurozone to the most accommodative level since 2007, and conditions in the US are also historically accommodative (see chart above). Other drivers of lending – such as bank lending standards – are also starting to ease again, as rates fall and risk appetite improves. Monetary policy works with ‘long and variable lags’, and there is still some risk that there is more economic weakness in the pipeline that is not yet visible. For instance, labour markets – particularly in the eurozone – are showing signs of weakness, and we do expect a small rise in unemployment over the coming year. However, the risk of a more severe slowdown or recession is diminishing. Provided that central banks do follow through on expectations to lower policy rates from June, our base case continues to see eurozone growth recovering back to trend by the end of the year, and although we do expect some slowdown in the US, this is unlikely to be long-lasting given the turn-around in financial conditions.