Is the return of US real income growth good or bad news for investors?
While excess savings have almost been exhausted, inflation’s sharp fall has brought an end to the squeeze on real pay. This raises the possibility of a soft landing, but it may also mean that the Federal Reserve has to raise rates even further.
Nobel prize-winning economist Milton Friedman once remarked that “inflation is taxation without legislation”. Few Americans would disagree with that statement given their experience over the past few years. Because while worker compensation has grown at the fastest pace for a generation, this has been more than offset by the sharp rise in inflation that has upended decades of low and stable prices.
Despite this, real household consumption has grown consistently over this period. As the US had neither a job retention nor a wage subsidy scheme during the pandemic, some 22 million workers were initially laid off. So as restrictions were then gradually eased, firms rebuilt their workforces which in turn served to sustain strong and steady consumption growth.
It therefore makes more sense to look at real household spending in absolute terms. And it is even more remarkable on this measure. Not only did it regain its pre-pandemic level in the space of a year, it subsequently went on to outpace the prior decade’s trend even amidst the sharpest and most prolonged real income squeeze of the past 40 years. So just how were households able to achieve this?
Savings are dwindling...
Put simply, consumers have been able to plug the shortfall using the ‘excess’ savings that they accumulated during the pandemic. Contributory factors include direct fiscal transfers, such as stimulus cheques, as well as indirect assistance such as eviction and student loan moratoriums. Also, social distancing rules and business closures in 2020 narrowed the outlets for consumer spending, which also caused savings to rise.
Chart: Excess savings have served to plug the shortfall in real incomes, but they have now been almost completely exhausted
By our estimates, these factors generated just over $2 trillion in excess savings. But these have almost been exhausted, with only around 8% remaining. And so we suspect that households will increasingly put aside more of their disposable income. In isolation, this would serve to weigh on household consumption later this year, alongside other factors such as the resumption of student loan repayments.
But real income growth has finally returned
Still, there has been an overriding development; real income growth has finally turned positive again. Falling inflation has been the main driver, with the annual rate of CPI easing from a peak of 9% to just 3% in the past year. And while the scope for further falls is limited now that the surge in energy prices has mostly unwound, there are similarly few reasons to expect inflation will break sharply higher in the near-term.
All the while, leading indicators suggest that compensation growth will moderate but remain at respectable rates. And widespread layoffs do not appear to be on the cards for now. As such, it appears that US consumers look set to enjoy a period of real income growth for at least the next year, which could well be enough to sustain spending even in the face of the headwinds that are set to emerge.
Chart: Fall in inflation has seen real income growth turn positive again, which looks set to be sustained over the next couple of years
Is real income growth good or bad news for investors?
On the one hand, this adds to the growing evidence that the US economy could be heading towards a soft landing. Conditions in the labour market appear to be gradually normalising from excessive levels and there are signs that the manufacturing sector is beyond its cyclical trough. Moreover, core CPI inflation has eased markedly after stripping out idiosyncratic outliers such as shelter and used car prices.
However, investors should be equally concerned about the end of the real income squeeze. Households may not save a greater proportion of their income, as we expect, but instead allocate more of it towards additional spending. This could cause supply-side strains to re-emerge, leading to a resurgence of inflationary pressures and the prospect of second-round effects.
These two bimodal outcomes are among the risks we flagged in our latest forecast. On balance, we judge that a ‘soft landing’ would relieve some of the pressure on inflation, allowing the Federal Reserve (Fed) to cut interest rates sooner and to lower levels. Whereas under the alternative ‘consumer resilience’ scenario, the committee would have to raise rates more and tip the economy into a deep recession.
Charts: Improvement in real incomes could result in one of two bimodal outcomes
Two factors to watch
Which of these outcomes might materialise depends on two factors. First, is whether productivity can keep pace. It spiked higher in 2020 as low-skilled consumer-facing workers were laid off while more productive employees were able to switch to remote working. Productivity has since steadily weakened as the composition of the labour force has then normalised, such that it has reasserted itself with its trend.
Whether productivity will now be able to keep pace with real wages is unclear. There are reasons for optimism, given the considerable capital spending by businesses off the back of the Inflation Reduction Act. But such investment does not always translate to productivity gains, which can be influenced by a range of factors. Either way, it is something we will be closely monitoring in the quarters ahead.
Meanwhile, the second determinant is whether the participation rate recovers. It remains some 0.7 percentage points below its February 2020 level. This shortfall has been concentrated among older workers who have taken early retirement and are unlikely to return in sufficient numbers. Rather, any recovery in participation will likely have to come from immigration, which encouragingly has rebounded sharply.
Charts: Achieving a soft landing will be dependent on productivity reverting back to trend and participation recovering further
Providing that productivity reverts to trend and labour supply improves, a soft landing is the most likely outcome. But unlike in the scenario we set out in our forecast, the unemployment rate is still some 0.8 percentage points below estimates of the NAIRU. And so in the absence of a recession, it may therefore take a prolonged period of sub-trend growth in order to rein in excess demand sufficiently.
As such, while the softening in inflation and job gains means that the Fed’s latest hike is likely to have been its last, we also suspect that a Fed pivot is further out in the distance. Ultimately, the committee is likely to remain concerned about the risk of second-round effects and thus remains patient to ensure it does not prematurely loosen policy in order to safeguard against the risk of our consumer resilience scenario.