What if the world’s largest economy refuses to decelerate?
That’s the $26 trillion question looming large over the monetary policy debate, and not just in the US either. Fed policy echoes and reverberates. If they’re forced to ratchet rates ever higher, it won’t happen in a vacuum.
In a new note, Goldman’s Spencer Hill explored three upside growth risks for the economy, and the read-through for the Fed. Although the bank doesn’t see a truly compelling case for a marked re-acceleration in manufacturing and housing, they do for consumption, where Hill called the math “compelling.”
The bank recently revised its 2023 real disposable personal income forecast higher, to 3.75% on a Q4/Q4 basis, reflecting stronger payrolls and re-indexed tax brackets. In addition, if wages stay elevated and inflation moderates even a little bit, that’s a boon to real pay and cost of living adjustments reset materially higher.
To account for the fact that higher income households have a lower marginal propensity to consume, Hill haircuts the projected real DPI gain by 50% to get a Q4/Q4 consumption forecast of 1.8%. “Higher interest rates on savings deposits are unlikely to drive consumption growth for younger and lower-income consumers whose financial assets are low relative to incomes,” Hill wrote.
And yet, he cautioned that “predicting changes in the savings rate is notoriously difficult, and we cannot rule out a scenario in which consumers spend a larger share of their incremental income — particularly given around $1.5 trillion of excess savings still on consumer balance sheets and credit balances still comfortably below the pre-pandemic ratio (as a percent of income).”
Given that, it’s possible consumption could be even higher — 2.5%, as shown by the second red marker in the visual below.
Consumption drives the US economy. If the upside consumption scenario were to play out, it’d equate to a half-point boost to overall GDP growth.
Hill said that high frequency data suggests goods spending remained above Q4 levels in February, while data covering the services sector “tell a similar story.”
The bottom line: Goldman sees “a significant risk that consumption will grow at an above-potential pace in 2023, in spite of a likely rebound in the saving rate.” Summarizing, Hill wrote that,
The income arithmetic is compelling: We forecast +3.75% [disposable income] on a real basis due to continued job gains, positive real wage growth and a boost from the indexation of social security checks to prior-year inflation. Even ignoring higher interest income, real disposable incomes would be on track to rise 2.5-3% this year. These disposable income numbers pose upside risk to our +1.8% real consumer spending forecast, and both official and high-frequency data suggest this upside may already be materializing. Census retail sales jumped 1.2% on a real basis in January, and Fiserv credit card data and Affinity Solutions services spending data suggest that consumption remains well above Q4 levels.
As noted above, the bank doesn’t currently believe the case for a re-acceleration in manufacturing and housing is as compelling as it is for consumption, but they didn’t completely write such an outcome off either.
For the economy as a whole, just the upside to spending could be enough to push GDP growth above potential, assuming it’s sustained.
In what the bank called a “blue sky” scenario where consumption, manufacturing and housing all re-accelerate, “the underlying strength in demand would threaten to raise 2023 GDP growth to +2.5%,” Goldman said.
What does it all mean for the Fed? Well, nothing yet unless they want to be preemptive. But if just the upside case for consumption is realized, Goldman said the Fed could “approximately offset this by delivering an additional 50bps in unanticipated hikes,” taking rates to 6% later in 2023.
As for the “blue sky” scenario, Hill wrote that “an even larger increase in the funds rate might ultimately be required to slow growth and to contain and reverse labor market overheating.”
