In a supply-constrained world, reducing asset prices may be the only way for central banks to bring demand and inflation lower. Otherwise, households with hefty savings will keep on spending, and firms will keep passing rising costs to consumers. We believe this vicious circle can be broken by worsening households’ or companies’ financial positions.
We analyze the evolution of U.S. household balance sheets and the Federal Reserve’s increasingly hawkish rhetoric.
Households relatively flush with cash
Let’s look at savings. Most American households had strong balance sheets at the end of 2021. Aggregate household net worth as a percentage of personal disposable income has trended higher over the past 20 years. This uptick, however, is at odds with the centuries-old observation that asset-to-income ratios are stable. All sound economic theories were built on a stable ratio because a market economy can’t sustain a rising or declining trend for long.
Demographic changes or intergenerational government transfer programs can lower or raise the ratio. While an increase in the share of the working-age population can gradually lift the asset-to-income ratio and can partly explain the uptrend in the United States, it cannot account for the sudden surge since the beginning of the Covid-19 pandemic.
Now, consider debt. The aggregate household debt-to-income ratio has declined from its peak in late 2007. Households had to deleverage as the housing bubble burst. The current debt-to-income ratio of a little over 100% hovers around the last two decades’ average. Home mortgages, the largest component of household debt, represent about 65% of personal disposable income. That is down from around 100% at the end of 2007.
Disposable income and household wealth in the U.S. have been rising
Source: Federal Reserve, as of 12/31/2021
Relatively low debt ratios should limit the immediate impact of rising mortgage rates on household finances. In addition, the share of households with adjustable-rate mortgages is miniscule, and the inventory of homes for sale remains low. The rise in mortgage rates should slow demand “growth” while housing supply is constrained. So, despite the surge in mortgage rates, the slowdown in the housing market will likely be gradual.
Stock ownership is rising
The asset side of U.S. households’ balance sheets has changed even more dramatically since the early 2000s. The values of real estate and consumer durables have risen faster than the incomes of most American families. Surprisingly, the increase in financial assets is the key factor behind the surge in household assets.
Reflecting the booming equity markets, households’ ownership of company shares has risen in the past decade, especially since the beginning of the pandemic. Today, the share of equity ownership in gross assets is about one-third. That share was around 13% when the Fed succeeded in delivering a soft landing in 1994 and just around 8% when former Fed chair Paul A. Volcker tamed runaway inflation in the 1980s. The real estate equity-to-gross asset ratio, however, has been stable. It was about 25% in the early 1980s and in 1994, and about one-third during the housing bubble in 2005–2006. The ratio currently stands at about 23%.
Bond ownership among U.S. households remains relatively low. Although some families own bonds indirectly via bank deposits or defined pension entitlements, the share of those assets has not increased. Only equities, as a share of total assets and in absolute terms, have risen noticeably. As the Fed reduced rates by buying U.S. Treasuries and mortgage-backed securities, households shifted to equities, which offered more attractive valuations and yields. The Fed’s quantitative easing program lifted the value of household assets and changed their composition.
The Fed and a soft landing
Higher interest rates will take time to affect strong household balance sheets. This could keep inflation elevated for longer than the Fed can tolerate. This is partly why the Fed turned its focus to financial conditions. By tightening financial conditions (lowering asset prices, for example), policymakers can sensitize households to rising prices and rates and, hence, reduce inflation.
The Fed knows higher policy rates will decrease asset prices, in our view. Still, the central bank does not know how much of an increase in interest rates will bring asset prices low enough to re-sensitize households to price changes. What the Fed has observed is that despite its very hawkish stance, financial markets are resilient, companies are maintaining their margins, and households are spending and purchasing big-ticket items. As policymakers get increasingly hawkish, the probabilities of a recession and its depth are rising.
Considering the composition of household balance sheets, it is possible the Fed will have to bring share prices significantly lower to increase households’ price elasticities. High equity ownership and elevated price-to-earnings ratios compared with historical averages make equity prices the ideal target.
If there is a recession — due to elevated share prices and high household exposure to the stock market ¬— it may look like the 2000–2001 recession. We believe equity prices may still correct should the United States avoid a recession through a soft landing.