What makes the US economy so resilient?

The Federal Reserve’s decision to keep interest rates on hold at last week’s Federal Open Market Committee meeting was widely anticipated by investors, who remain hopeful that the tightening cycle is nearing an end. However, the latest FOMC projections indicate that the funds rate could be increased one more time this year and stay high next year.  

The main surprise thus far is the economy’s ability to weather rate hikes of 525 basis points over the past 18 months. The term “resilience” is widely used to describe what has happened. 

Yet, this begs the question: “Why is the U.S. economy so resilient?” To answer it, one needs to consider factors that have made the U.S. economy highly adaptable to an array of shocks over the past 50 years.  

One of the most important lessons over this period is that the U.S. economy is more sensitive to the availability of credit than to the cost of credit.  

This first became apparent during Paul Volcker’s tenure as Fed chair that began in 1979. Volcker was committed to ending a decade of high U.S. inflation and set out by scrapping the Fed’s policy of targeting the fed funds rate in favor of controlling bank reserves. When the funds rate spiked to 17 percent in early 1980, virtually all forecasters anticipated a severe recession.  

Instead, the economy held up reasonably well until the Fed implemented a voluntary credit restraint program in March of 1980. Thereafter, the economy swooned within a matter of days and the funds rate plunged. The program was subsequently phased out in early July, and both the economy and interest rates rebounded quickly. 

This lesson about the consequences of a credit squeeze was reinforced during the 2007-08 financial crisis. Credit markets seized up when market participants could not assess the values of complex mortgaged-backed securities and the exposures of financial institutions to them. The recession that ensued was the worst in the post-war era, and the Federal Reserve was compelled to pursue unorthodox monetary policies to prevent a 1930s-style collapse of the financial system. 

Ben Bernanke analyzed what happened in a Brookings paper 10 years later and concluded that “the severity of the Great Recession reflected in large part the adverse effects of the financial panic on the supply of credit. In particular, the housing bust alone can’t explain why the Great Recession was as bad as it was.” 

The main reason the economy has been able to absorb rate hikes today is they impact sectors differently. The banking sector is particularly vulnerable because banks have to manage a maturity mismatch between long-term loans and short-term deposits. The failures of Silicon Valley Bank and Signature Bank this spring raised concerns about the ability of regional banks to manage interest-rate risk. While bank problems have been contained thus far, the Fed and market participants are monitoring a tightening in bank credit. 

Another sector that has been impacted is housing, as mortgage rates have more than doubled this year. However, because homeowners with 15 or 30-year fixed-rate mortgages are locked into low rates, they do not feel the effect of higher mortgage rates today.

Similarly, unlike most countries, U.S. corporations are able to raise long-term debt. James Mackintosh of the Wall Street Journal points out that some of the biggest and most secure U.S. companies have been beneficiaries of higher interest rates because they locked in rates when they were low.  

Apart from interest-rate sensitivity, several other characteristics of the U.S. economy have helped to mitigate the severity of U.S. recessions.  

First, the economy is highly diversified. The five largest industries, which account for about two-thirds of GDP, are dispersed. This lessens the impact of a shock on the overall economy because some industries fare better than others. It is the basis for the argument that the U.S. economy is experiencing a “rolling recession.” 

Second, the U.S. labor force is highly flexible. During the two oil shocks in the 1970s and 1980s, there were large migrations of workers out of the Rust Belt and into the Sun Belt. Thereafter, labor mobility lessened as this migration ran its course. However, when the COVID-19 pandemic struck and workers lost their jobs or became housebound, many became self-employed and entered the gig workforce.

This is testimony to the rapid expansion of the digital economy in America. The Bureau of Economic Analysis estimates that as of 2018, it accounted for 9.0 percent of GDP and 5.7 percent of jobs. It is the fastest-growing sector since 2006, with an average annual growth rate of 6.8 percent, or four times more than the overall economy.   

Third, U.S. multinationals are also very dynamic and global leaders. What stands out is how the largest companies ranked by market capitalization have changed over time. Today, U.S. multinational corporations dominate the rankings: Four of the five largest companies in the world — Apple ($3 trillion), Microsoft ($2.4 trillion), Alphabet ($1.7 trillion) and Amazon ($1.4 trillion) — are headquartered in the U.S., and only five in the top 20 are outside the U.S.  

Weighing these considerations, the resilience of the U.S. economy this year should not be considered a one-off event. Rather, it is part of a larger story about an economy that is well diversified, has a mobile workforce and benefits from entrepreneurial spirit.

Looking ahead, the biggest challenge will be to wean the economy off massive increases in government spending: Over the past 15 years, the ratio of government debt to GDP has doubled from 60 percent to 120 percent. While government intervention helped to shield the economy during the 2008 financial crisis and the COVID-19 pandemic, this rate of debt accumulation is unsustainable. It is now time to let the economy stand on its own and demonstrate its inherent resilience. 

Nicholas Sargen, Ph.D. is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including “Global Shocks: An Investment Guide for Turbulent Markets.”