Cash-Rich Consumers Prove a Challenge for the Fed

November 3, 2022

The Federal Reserve’s efforts to tamp down inflation by slowing the economy via tighter financial conditions are being stymied by the strong financial shape of U.S. consumers and businesses.

The Fed has made the unprecedented move of raising interest rates by 75 basis points at its four previous meetings, and while economists debate over how quickly rates will continue to rise, some are more concerned about high they will eventually climb.

In the most recent projections, most Fed officials anticipated that the federal funds rate will reach at least 4.6% by early next year. However, some economists believe it will have to go higher than 4.6%, particularly because spending has proven to be so resilient to higher rates.

The Fed combats inflation by tightening financial conditions, which in normal circumstances will curb spending and reduce employment, slowing the economy. In 2020, however, government stimulus left households with a huge amount of excess savings, which has interrupted the usual dynamics at play.

According to economists at Goldman Sachs, the household, nonfinancial corporate, and small-business sectors amassed a surplus of total income over total spending equal to 1.1% of gross domestic product in the second quarter. According to their research, household finances are healthier now than during any previous run-up to a potential recession since the 1950s.

U.S. households are still sitting on roughly $1.7 trillion in excess savings above what they would have saved if income and spending had grown in line with the pre-pandemic economy, according to estimates by the Fed. This is, in part, why consumer spending has remained so resilient even in the face of rampant inflation.

This means that slowing the U.S. economy may require even higher interest rates. Federal Reserve Bank of Kansas City President Esther George noted as much in a recent presentation, saying that the household savings buffer “suggests to me we may have to keep at this for a while.”

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