Economic Headwinds: De-leveraging & Inflation
The Federal Reserve's Flow of Funds report for the first quarter shows continued deleveraging in the US economy. The broadest measure of debt owed by the nonfinancial (i.e., non-bank) sectors — which includes the borrowings of private households, nonfinancial businesses, and all levels of government — grew just 2.3% (annualized) in the first quarter. This was the third-slowest pace since the series began in 1952; only the second half (Q3 and Q4) of 2009 was lower.
One key reason for the weak growth in debt was the continued paydown of household debt. In the first quarter, nominal household liabilities declined by 2.0% (annualized), the twelfth consecutive quarter of debt paydown, as shown in the second chart below. This has taken the ratio of household debt to disposable income down to 114%, from a peak of 130% in 2007.
The implications of the ongoing deleveraging process for the economy are double-edged. On the one hand, it partly explains the weakness of US economic activity in 2011 so far. The US private sector is still running a financial surplus of 6.3% of GDP, which means that the level of spending remains unusually far below the level of income. At a time when real income growth has been restrained by the sharp increase in energy prices, this has depressed the growth pace of spending.
On the other hand, the deleveraging suggests that households have continued to repair their balance sheets and are thereby increasing their ability to spend in the future. The Federal Reserve Board publishes quarterly data for the household debt service burden, defined as interest payments plus scheduled principal repayments as a share of disposable income. Although figures for the second quarter are not available, the first quarter of 2011 showed a drop in the debt service burden to 11.5%, the lowest since 1995 and down from a peak of 14% in 2007. The debt service burden includes household debt service payments and financial obligations as a percentage of disposable personal income, seasonally adjusted.
The decline in the debt service burden is translating into an improvement in household credit quality. According to the New York Federal Reserve, newly delinquent loans to households in the first quarter fell to $250 billion or 2.2% of total household debt outstanding, down from a peak of $405 billion or 3.3% of total household debt outstanding in the fourth quarter of 2008. In turn, improved credit quality is translating into a greater willingness of banks to make loans to consumers. The Federal Reserve's quarterly Senior Loan Officers' survey showed that the net share of banks indicating greater willingness to make consumer installment loans rose to 28.8% in the second quarter, the highest reading since 1994.
Over time, these improvements should feed into a pickup in household spending growth. Eventually, households will find that they have cut their debt stock sufficiently. At that point, spending should increase relative to household income. In turn, this should feed into stronger aggregate demand for goods and services, as well as positive multiplier effects in the labor market that again feed back into stronger income growth. The recent data suggest that this is a slow process, but we continue to believe that it will ultimately result in a stronger US economy.
In the context of weak economic growth, the significant acceleration of headline and core CPI inflation over the past year has been surprising. The surge in headline inflation (which includes food and energy) has been driven primarily by gasoline prices, which have eased somewhat in recent weeks. Even assuming a move to higher oil prices over the coming year, the rate of increase in both commodity prices and the headline CPI should decline.
The pickup in core inflation (still below the Federal Reserve's implicit target of roughly 2% inflation) has two main causes. First, rental housing and vehicle prices have normalized after a period of outright deflation during the crisis; we expect modest positive rates of inflation going forward but do not see major warning signs of a sustained acceleration. Second, rising commodity prices have passed through into a few components of core inflation. This pass-through effect should fade if indeed commodity price inflation moderates and inflation expectations stay anchored.
For core inflation to move significantly higher would probably require fundamental capacity pressures, which are still some ways off in most sectors of the US economy. While areas like manufacturing do appear to be reasonably close to equilibrium capacity, others like services and the broader housing market are clearly not. Most importantly, the labor market remains extremely soft, suggesting wage growth will not be a source of significant inflation for quite some time.
Jason Thomas, Ph.D., CFA
Chief Investment Officer, Principal