Excess savings are critical to the expansion’s duration

The American economy has shown resilience in the face of rising interest rates as consumers, bolstered by excess savings built up during the pandemic, have continued to spend.

But how long can these savings last?

According to our analysis of revised data from the Bureau of Economic Analysis, consumers are on strong footing, with $400 billion to $1.3 trillion in excess savings to draw upon as the economy moves toward price stability amid tightening financial conditions.

It's higher than previous estimates, and in the end may help steer the economy to a soft landing and avoid a recession.

We base our analysis on a recent significant revision to the National Income and Product Accounts data, which includes savings and income data, by the Bureau of Economic Analysis for 2017 to 2022.

The newly revised data shows that excess household savings were higher than previously estimated, and those savings will be a critical factor in the duration of the current economic expansion.

We anticipate growth of 3.1% in the third quarter and 0.5% in the final quarter as a probable government shutdown and resumption of student loan payments place a drag on economic activity. We then expect the economy to rebound with a 1.7% gain in the first quarter of 2024.

The major risk to the current outlook is rising interest rates and their adverse impact on financing commercial and industrial loans.

Excess savings will most likely continue to partially mitigate the impact of rising yields and the lagged impact of the Fed’s rate hikes.

Those savings should be able to fuel spending growth at least through the end of the year, according to our analysis.

Indeed, U.S. retail sales surpassed expectations in September, rising by 0.7% on a monthly basis and bolstering the case for a soft landing.

Our base case estimate points to about $400 billion—5.84% of annual gross domestic product—left in surplus savings at the end of August, which could total as much as $1.3 trillion depending on the calculation method used.

Such a wide range of estimates, together with the sharp data revision, explains why predictions on the path of the economy over the past year have shifted between a soft landing and a hard landing.

Based on the recent data revisions and our estimation of inflation-adjusted excess savings, we expect the economy to be able to skirt a recession, or a hard landing, and have downgraded the probability to 40% for the next 12 months.

At the current spending and savings pace, the base case excess savings would be depleted in the first quarter of next year, a lot later than the previous estimates of RSM and others.

If our estimate of inflation-adjusted savings proves too restrictive, the economy is likely to grow at a quicker pace next year than the 1.8% we expect for the full year.

Moreover, our new results account for the fluctuations in inflation over the past three years, which most other estimates have overlooked, and  underscore our confidence that the economy will avoid a recession.

Our forecast implies that disinflation will continue well into next year, especially as rents, which are easing notably in other high-frequency data, begin to exert a powerful downward drag on the official data.

We anticipate that two important measures of inflation—the top-line consumer price index and the core personal consumption expenditures (PCE) price index—will end the year at 3% and 3.4%, respectively, and then ease to 2.5% in each aggregate by the end of next year.

But even when the savings surplus is completely drawn down, it does not necessarily translate to a recession.

Because all methods used to calculate excess savings have to benchmark against pre-pandemic trends, the economy could simply go back to its pre-pandemic trend, where GDP growth averaged a healthy 2.2%.

There undoubtedly is a clear path to a soft landing given the strength of recent economic data in addition to the savings surplus.

The important conditions for a soft landing, however, will remain a strong labor market and further disinflation that can keep real income growth steady. 

Defining excess savings

Because excess savings has no textbook definition, there is no one method to calculate it.

Our earlier estimates of excess savings had followed a Federal Reserve study last year by Aditya Aladangady, David Cho, Laura Feiveson, and Eugenio Pinto. But that study was done before the data revisions, and the study's results did not fully account for the fluctuation in inflation, which surged to more than 7% last year.

The authors acknowledged that for simplicity, they assumed prices moved along their pre-pandemic trend, but that has not been the case. To see the impact of high inflation on excess savings, consider the following simplified equation:

In this equation, excess savings is a function of income, spending, outlays and "normal" savings. If inflation increases, consumers earn less income on an inflation-adjusted basis, need to spend more to achieve the same level of consumption, and finally must save more to meet their savings expectations. All of these factors will erode their excess savings.

Even though inflation has come down from its multidecade high last year, failing to account for inflation, which remains above the pre-pandemic average, would skew the estimate for excess savings to the upside.

In our base case, instead of using nominal savings to calculate excess savings, we use inflation-adjusted savings, or real savings using the PCE price index. We then use the 2015−19 period as the benchmark to calculate the real savings trend for the post-pandemic period. Excess savings is the difference between actual savings and the pre-pandemic savings trend. Finally, we convert real excess savings back to nominal excess savings using current dollars for interpretation. 

From the start of the pandemic to the middle of 2021, American households accumulated a large amount of excess savings, peaking at a minimum of $2.2 trillion.

Since then, because of rising prices, no new fiscal support, and consumers spending to fulfill their pent-up demand, monthly excess savings have been declining.

That leads to our calculation that by the end of August, close to $400 billion remained in savings surplus in current dollars, or about 5.84% of annual GDP.

That total should be enough to keep the economy chugging along despite headwinds in the final quarter.

Alternative methods

Instead of using real savings level, other studies have used savings rate trends and average savings rates to calculate excess savings. With the revision to the National Income and Product Accounts data, both of those methods produce much higher estimates for total excess savings.

We do not use those methods as the base case because of the volatility in savings rates, which are often affected by exogenous factors like the federal funds rate, alternate saving sources like financial assets, and even demographic changes.

The real savings level trend is much more reliable, not only for its simplicity and ease of use but also for the ability to control for a consistent level of savings for future consumption regardless of changes in prices or exogenous factors. 

For robustness, however, we show the results of all the different methods, where the red line is our base case. For the orange line, we used the savings rate trend from 2015 to 2019 to calculate excess savings, benchmarking against real disposable income.

The green line depicts the savings rate average from 2015 to 2019 instead of the upward trend, also benchmarking against real disposable income. The light blue line reflects the savings rate trend but with nominal disposable income, and the dark blue line depicts the nominal savings level trend instead of real income.

The impact of inflation rising above the Federal Reserve’s target of 2% since the middle of 2021 shows up in the figure through the divergence of our inflation-adjusted excess savings method away from other methods that do not account for price changes.

Because our base case reflects the worst-case scenario for excess savings, it serves as another signal that the economy should be able to withstand the Fed's aggressive rate hike campaign in the coming months.

Excess savings by income quartile

We apply the same savings ratios by income quartile found in last year’s Federal Reserve study to extrapolate the distributions of excess savings using the new results.

Nearly half of the $400 billion in excess savings was held by the top 25% income earners—$191 billion by the end of August. The bottom 50% of earners accounted for only 20% of the total savings surplus.

That implies that the main driver of spending in the final quarter will be the top income earners, while the bottom income earners will most likely struggle as the economy slows.

It is important to note that monetary policy is not designed to favor one group over the other. The task of addressing unequal outcomes is a function of fiscal policy, which has not had a good start in the fourth quarter because of the great rate reset pushing yields to multidecade highs, the resumption of student loan payments and a looming government shutdown that affects lower-income households much more than others.