## CAFÉ ECONOMICS — Reading the Tea Leaves on Household Debt

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**Canonical URL:** [CAFÉ ECONOMICS — Reading the Tea Leaves on Household Debt](https://www.imf.org/-/media/files/publications/fandd/article/2022/december/cafe-economics.pdf)

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### State of household debt and recession risk
- A significant rise in household debt—encompassing all consumer debt and mortgage loans—has historically signaled the possibility of a looming economic recession.
- During the COVID-19 recession, private-sector and housing-market debt did not explode as in the global financial crisis because:
  - There wasn’t any noticeable expansion in credit in the lead-up to the pandemic.
  - The COVID-19 recession was driven by factors unrelated to the financial sector and lacked the boom-bust dynamics typical of credit-driven recessions.
  - Government interventions in the United States—such as aggressive mortgage forbearance policies and major fiscal stimulus—helped mitigate household financial distress, softening impacts on household balance sheets and default rates.
- Current household balance sheets in the United States are described as “quite healthy,” partially due to strong fiscal stimulus, which reduces the typical impact of rising interest rates on consumer spending.

### Drivers of current inflation, interest rates, and economic effects
- Current inflation is tied directly to:
  - Fiscal stimulus.
  - Cost shocks, in particular those from energy and supply chain issues.
- Usual recession channel: households with high debt see interest-rate-sensitive debt costs rise, reducing consumer spending; this time the effect is tempered by healthier household balance sheets.
- Nevertheless, inflation is already reducing consumer spending (e.g., CEOs of retail firms report a strong decline in consumer spending due to inflation).
- Interest-rate increases chiefly affect interest-rate-sensitive sectors such as housing and auto purchases.
- Interviewee’s view on return to low rates and inflation:
  - Expectation: “we’ll be back to a low-inflation, low-interest-rate equilibrium three to five years from now.”
  - Rationale: secular factors pushing down interest rates; current episode largely due to aggressive fiscal stimulus and cost shocks; central banks will succeed in affecting inflation expectations.
  - Caveat: the war in Ukraine and climate change could spur large rises in military spending and green investment, which could put upward pressure on interest rates and inflation over the next few years.
- Market signals cited:
  - Longer-term yields on government bonds remain low.
  - The yield curve is inverted.
  - Market expectation is that long-term interest rates will probably continue to be low.

### Country vulnerabilities and specific cases
- China:
  - Expectation of a deterioration in economic conditions, not only due to COVID-19 lockdowns but also because of the property market.
  - The property problems in China are likely to be a major drag on their economy and follow a path that typically leads to a severe recession.
- General vulnerability pattern:
  - Countries with very elevated household debt, collapsing investment and spending, or housing-price declines could see more difficulty, but current global conditions differ from typical severe recessions because private-sector debt is not universally elevated.

### Government debt, fiscal space, and constraints
- Advantage of government debt: people are willing to hold it at an interest rate below market rates on other securities, which helps governments that want to run deficits.
- Common misconception addressed: the idea that if the nominal interest rate is below the nominal growth rate one can increase deficits indefinitely is not accurate.
  - As government debt saturates the market, people value government debt less, and the interest rate on government debt must rise.
  - If deficits are raised too much, the nominal interest rate can exceed the nominal growth rate, forcing deficit cuts.

### Risks from surge in private and public debt
- Post-pandemic surge in private and public debt amplifies a Japan-style risk:
  - Very long-term depressed growth.
  - Debt burdens that get larger.
  - Depressed interest rates.
  - Depressed inflation.
- Expansion of government debt that is not used productively adds to that risk.
- To reduce debt burdens through growth, policies must boost productivity and reduce income inequality in productive ways—examples include policies that boost middle-class wages and add to demand, encouraging firms to invest.

### Housing, inequality, and the long-run stagnation trap
- Higher household debt is a symptom of deeper problems: the economy’s inability to generate enough demand given the rising income share of the people at the top.
- Rising income inequality:
  - Pushes up asset prices and pushes down interest rates.
  - Leads to insufficient demand, leaving middle- and lower-income households to borrow more to generate demand.
- Real risk described: a long-run stagnation trap characterized by a high-debt, low-interest-rate, low-household-spending equilibrium.

### Policy recommendations
- Infrastructure spending is recommended, especially when it can:
  - Boost productivity.
  - Boost middle-class wages.
- Rationale:
  - Because interest rates are low, governments can borrow to fund infrastructure that potentially yields good productivity growth and helps address inequality-driven demand shortfalls.
- Broader policy imperatives:
  - Find ways of increasing productivity growth.
  - Find ways of reducing income inequality in a productive manner (for example, boosting middle-class wages to increase demand and encourage investment).

*Finance & Development, December 2022.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2022/december/cafe-economics.pdf_