How Consumers Will Keep Powering GDP Growth

Wharton Business Daily: Third quarter GDP from the Commerce Department is showing growth at a whopping 4.9%, the largest we’ve seen in several quarters. But what does that tell us about the state of the economy and where it is headed? It’s a pleasure to be joined by Nick Roussanov, who is a professor of finance here at the Wharton School. Nick, great to talk to you again.

Nikolai Roussanov: Hi, Dan. Great to be here, as always.

WBD: So, what’s unique about this report – is it a big number? If you go by a lot of the reporting out there, it seems like the expectation was there at least for a couple of weeks that this was probably going to be a big number.

Roussanov: Indeed. But even those expectations were beaten. I think the consensus was 4.7% — 4.9% is a little bit higher than that. But yes, we had seen the economy kind of accelerate over the last few months of the third quarter. In fact, if you look over the whole year, despite the fact that we had a slowdown towards the end of 2022, over the whole of 2023 so far, we’ve had GDP growth accelerating rather than rather than slowing down.

WBD: What do you think what was behind this latest report? Especially, I guess, we’re looking at that late summer, heading into fall, time of the year.

Roussanov: Well, if we drill into it, we see that it is — as is often the case — powered largely by consumption. The consumer is doing the job of keeping the economy going. The personal incomes are not growing as fast, though, so we see consumers potentially dipping into their savings. We don’t see that much expansion and borrowing yet, although there’s certainly some despite the fact that we’ve had the highest rates on credit card debt ever in recorded history, due to the tight monetary policy or tightish monetary policy. It’s not that tight yet, but compared to what we’ve had recently, it certainly seems that way. Yet the consumer is still consuming. The consumer expenditures and durables, nondurables, services, are all up and all quite strong.

WBD: Do we think that we’re at a point, or getting close to a point, where this backlog of cash and financial support that a lot of consumers had, that they have kind of worked through it at this point?

Roussanov: Oh, they haven’t, I think, fully worked through it. But I think they’re working on it. The massive growth in savings and bank deposits that we saw in the pandemic, obviously, has been slowly reversing. But I don’t think we are yet at the point where the typical consumer feels like they’re tapped out. Certainly it’s going that way, if incomes don’t pick up. But again, I think that there is some reasonable sense that personal income growth will actually catch up with the GDP numbers. In fact, what we saw in the previous quarters is that GDP was up and gross domestic income, which is kind of the other measure of output as based on income, was lagging behind. And that typically means one of two things. Either GDP will slow down, or income will pick up. And in fact, we saw income sort of catch up with GDP, as opposed to the other way around.

So it might well be that, as the workers are renegotiating their pay across the whole economy — it’s not just the auto workers. This is happening throughout the economy. The labor market is incredibly strong. Employment numbers are incredibly strong. And I think the the employees are having their bargaining power in their hands now, and we will see some of that translate into income growth, at least for the workers. Now, of course, capital income might take a hit as a result, and where that kind of balances out is yet to be seen. And whether that in itself will bring about a slowdown is also something of an uncertain projection.

WBD: Expand upon that a little bit more, about the workers and the issues of wages. Because we’ve obviously talked about it a lot with the auto industry, and how they’re renegotiating their contracts. It’s gone on a little bit, obviously, in Hollywood as well. But it sounds like there are elements of that going on just kind of across the economy right now.

Roussanov: Absolutely. That’s what happens when the labor markets are tight and the economy is relatively strong. In fact, quite strong. And so the labor demand is strong. And yet there’s just not enough workers. That means that workers do have the bargaining power that they have not enjoyed for perhaps some decades. And of course, in these heavily unionized industries, like the auto, and in some sense the entertainment industry, we see those very visible signs of that with strikes and so on. But in the rest of the economy that is not as heavily unionized, we just see it through employers having to offer higher wages to new hires to attract new hires. Because again, we have a bit of a labor shortage going on.

WBD: And it seems like we still have a lot of companies out there that are very much protective of the workers they already have. They don’t want to see them going off to another company or leaving for, you know, if they want to do a startup. They want to keep them in in that base.

Roussanov: Absolutely. And that is, again, supporting potential for income growth of those workers that we might see going forward.

WBD: All right. So is the expectation, then, that we probably won’t see the Fed raise rates anytime this year, because of a lot of these dynamics at play?

Roussanov: Well, the Fed is in a tight spot here. And by the conventional wisdom, I should say, that the Fed follows, they cannot really bring the inflation down without slowing down the economy sufficiently. And yet, what we see is the economy is not slowing down. If anything, it looks like it’s accelerating. And again, employment is super strong. And yet, inflation has been coming down. And in some sense, the only dangerous spots are not so much the economy being strong, but supply shocks like in the energy sector. Oil prices have gone up over the summer. Those are the things that the Fed doesn’t have much control over and it would be kind of strange for them to react to that as an inflationary pressure and raise rates. So, they’re not expected to raise rates in this meeting that’s coming up this week [on November 1]. And it’s unlikely that they would raise rates in the next meeting after that as well, although, of course, it’s possible. It depends on what inflation numbers we see. But I suspect that we’ll see inflation continuing to slow down, but at a slower and slower rate.

So, I feel that we are potentially approaching a more or less steady level of inflation that is higher than what the Fed would like to see. They want to see 2%, and we’re going to be more like at 3% for the foreseeable future. And that puts them in a tight spot, because pushing rates further up, I think, is dangerous for the banking system, for the mortgage market, for the housing market. And yet, they need to do something if they don’t see inflation coming down.

I think [rates are] going to be higher for a longer scenario. They’re going to say, “Well, we’re going to keep rates up as long as it takes. And if need be, raise them further.” I don’t see hikes in the immediate horizon. Although, the fact that we saw the yield curve flattened quite a bit — now, the 10-year yields are pushing 5% here and there, so the yield curve is not as inverted as it was before — suggests that the strong growth expectations are also indicating the potential for Fed to maybe continue tightening. But [they’ll] certainly hold rates higher for longer.

WBD: What’s interesting is when you hear some other economists and analysts, especially ones that follow the bond market — I mean, you hear some of them talking about potential yields of 6%, 7%, 8% that we might see here in the next several months.

Roussanov: Sure. It’s possible. And I think part of that is the increase in the risk premium. Now the risk premium, of course, is kind of a nebulous concept in the end, and it’s not something that we see. It’s really the difference between the the market’s expectations of future short-term rates, and what today’s long maturity yields indicate. But I think much of the talk is about the fact that the Fed’s quantitative tightening and investors shrinking appetite for U.S. government bonds — in part because of the Fed’s aggressive tightening policy, but also the worries about the U.S. deficit and what is it going to lead to in the long run — means that the long-term yields are going to have to pay more. And yeah, I don’t think that 6% is crazy. Higher than that is unlikely, but certainly possible. Certainly, there is more uncertainty about inflation picking up again.

Though again, we don’t know what the risk premium really is. But they all suggest that there’s not much of the expectation of a Fed cut anytime soon. I think we’ve been through this narrative throughout much of the last year, with the yield curve being inverted, that while the Fed is slowing down the economy enough, they’re going to have to cut soon, especially if something that looks like a recession shows up on the horizon. This does not look like a recessionary economy in any way. So, unless the Fed really pushes it that way, it’s not what we’re going to see. And in an expansion, typically, the yield curve actually steepens with the long maturity yields going up. And I think that’s behind some of that consensus.

WBD: Does it feel like the rate increases that the Fed has put into play over the last year and a half are finally starting to have some teeth when you think about the day-to-day economy for the consumer here in the U.S.?

Roussanov: It’s certainly affecting the consumers who are borrowing on credit cards, or through auto loans, and so on. Now, credit card borrowing is not a big driver of consumption right now, because most consumers have quite a bit of liquid savings as we talked earlier. Where I think it’s biting the most, of course, is the mortgage market. We now have the highest mortgage rates in over two decades. And that is certainly making this housing market kind of weird. It’s not just that the homebuyers are put off from buying. It’s also the sellers that are put off from selling, and don’t want to give up their 2.5% or 3% mortgages to get into an 8% mortgage. Right?

Now, that’s a bit of a quirk of how the U.S. mortgage market works, that you cannot take your mortgage with you or the mortgage is not attached to the house like it is in some other countries. But it is having, I think, the effect of — both the supply and demand in the housing market are kind of constrained. And, if nothing else, that causes misallocation in the economy.

And it makes it harder for people to move to new jobs. Again, we’re talking about labor shortage. Well, labor shortage is particularly acute in some sectors in some areas. And if labor mobility is constrained by the consumers’ unwillingness to move because they don’t want to give up their 2.5% mortgage, that’s not going to help address that labor shortage. And so some of those misallocation effects are potentially going to start showing up. It’s not a very direct, “Well, the rates are up, we’re gonna stop consuming.” It’s more of an indirect increase in frictions all through the economy that we’re going to see, which could slow the economy down. It’s just going to take some time.

WBD: For those who follow it quarter by quarter now, what’s the expectation we should be looking at for fourth quarter GDP? Obviously not up at 4.9%. But still probably not down in the ones either, especially with the holidays coming up?

Roussanov: I should tell you that I’m on the U.S. Macroeconomists panel that the FT puts puts on. And in our last survey, the consensus estimate for U.S. real GDP growth for the year 2023 was about 2%, with 2.5 being the upper bound. Ninety percent confidence interval, meaning that there’s only 10% probability that it will be higher than that.

Well, with the numbers that we just saw come in, it would take a big drop in the fourth quarter to get anywhere close to what we as a group had expected. So, I think everybody’s revising their expectations upwards quite a bit. I think, given the large numbers we’ve seen, anywhere between 3% and 4% annualized real growth in the fourth quarter is not out of the question. I think it will be lower. But I think for the year as a whole, we’ll probably end up seeing certainly between 2.5% to 3% growth. That’s my expectation.