US Economy Is Less Interest Rate Sensitive

Ed Yardeni & Eric Wallerstein

This is an excerpt from the May 29, 2024 Yardeni Research Morning Briefing.

US Economy I. Banks Versus Nonbanks. The resilience of the US economy has been impressive over the past two years in the face of the Fed’s dramatic tightening of monetary policy. Nevertheless, there are still a few hardcore hard-landers predicting that the economy either is already in a recession or soon will be. They’re convinced that there are long and variable lags between restrictive monetary policy and its depressing impact on the economy. Among them is one of our competitors who seems to give a lot of weight to the Senior Loan Officer Opinion Survey (SLOOS). SLOOS, she says, suggests that credit conditions remain tight.

Eric and I disagree with this assessment. Here is why:

(1) We aren’t saying that SLOOS suggests credit is loose. We are saying that it has become a less important indicator of credit conditions in our economy than it used to be. That’s because banks have become less important agents of capital allocation in our economy as nonbanks have become more important sources of financing (Fig. 1). Private debt and private equity funds have been growing rapidly in recent years. So have distressed asset funds that have plenty of money available to restructure overleveraged assets, buying at significant discounts and then reselling at a premium.

(2) In addition, in recent years, economic growth has been driven by services and technology companies. They tend to have higher margins and cash flow and less debt than goods-producing companies, so they’re not as affected by rising interest rates and tightening credit conditions.

(3) Of course, the housing market remains very interest-rate sensitive. But residential construction’s share of nominal GDP has been falling (Fig. 2). It is currently only 4.0%, which is near the previous cyclical lows prior to the Great Financial Crisis (GFC).

(4) Auto sales also seem to have become less sensitive to credit conditions. Over the past 13 months, the total has fluctuated around 15.5 million units (saar) despite higher auto loan rates and slowing consumer credit for auto loans (Fig. 3 , Fig. 4, Fig. 5, and Fig. 6). Americans have been buying the bigger and more expensive motor vehicles. Light trucks now account for 81% of retail unit auto sales, up from 50% during 2012-13 (Fig. 7).

In any event, personal consumption expenditures of new autos as a share of nominal GDP has also been falling (Fig. 8). It is currently only 2.6%, which is the lowest since the previous cyclical lows prior to the GFC.

In the following section, Eric reviews the evolution of the US economy from a goods-producing one to a more high-tech and services-providing one, making it less interest-rate sensitive.

US Economy II: Goods Versus Services. Last week’s S&P Global flash PMI report for the US suggests that the manufacturing sector (i.e., the M-PMI) may be starting to recover from its rolling recession, or at least to bottom (Fig. 9). It rose to 50.9 in May. The flash PMI for US services (NM-PMI) was stronger, rising to 54.8. We are expecting a lackluster recovery in goods-producing industries that should continue to be offset by strength in services-providing ones.

Producing goods is capital intensive and requires lots of financing to start new projects and build manufacturing plants. Consumers often require financing for big-ticket purchases like autos. Typically, obtaining credit becomes tougher when the Fed raises interest rates. Banks pull back on lending, consumers are forced to retrench, and companies cut their payrolls to shore up their earnings. That script hasn’t played out in response to the Fed’s latest tightening round. That’s because the economy’s shift toward services and away from goods has decreased its sensitivity to higher interest rates.

Consider the economy’s transformation:

(1) Goods have fallen to 31% of what’s produced in America, per nominal GDP, while services have risen to 61% (the remaining portion of production is in structures and inventories) (Fig. 10). In the early 1950s, the former was over 50%, while the latter was under 40%.

(2) These macro-economic trends are driven by the all-important American consumer. Personal consumption expenditures make up 68% of nominal GDP—46% of that is services consumption, with the remaining 22% goods consumption (Fig. 11). During the 1950s, services consumption represented only about 25% of GDP and goods consumption about 40%.

As a share of total consumption since the early 1950s, spending on goods has fallen from about 60% to 33%, while spending on services has increased from just under 40% to 68% (Fig. 12).

(3) Fewer of America’s businesses are producing consumer goods and more are producing conventional services as well as high-tech goods and services. More of America’s goods consumption has been attributable to imports. As a result, manufacturing capacity and output have been flat since China joined the World Trade Organization in late 2021 (Fig. 13).

(4) Capital spending has shifted away from traditional manufacturing to high-tech industries. High-tech now accounts for half of all domestic nominal capital spending (Fig. 14). On an inflation-adjusted basis, business spending on information processing equipment exceeds spending on industrial equipment by 2:1 (Fig. 15).

Real investment in intellectual property (IP) has soared to a new high of $1.43 trillion (saar), while structures ($652 billion) and equipment ($1.25 trillion) have only recently returned to pre-pandemic highs (Fig. 16). IP now makes up more than 40% of nominal private nonresidential fixed investment (Fig. 17).

(5) The recent increase in corporate spending on manufacturing structures is undoubtedly tied to the Biden administration’s fiscal packages. Investment in manufacturing structures more than doubled from $64 billion in Q3-2020 to $147 billion in Q1-2024. Most of these new factories will be producing high-tech products such as semiconductors and electric vehicles.

(6) Services are still more labor-intensive than manufacturing. Soaring services spending in areas like restaurants, healthcare facilities, airlines, and hotels has boosted demand for workers. It’s mostly lower-income households that have benefited from this, via rising real wages from jobs in these industries.

A record 22.3 million Americans are employed in healthcare and social assistance, 17 million work in leisure and hospitality, and 23 million work for government (mostly state and local). In contrast, all goods-producing industries combined employ just 22 million people, constituting only 10% of payroll employment, down from over 30% in the 1950s (Fig. 18).

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