US consumers and rising rates

As Fed monetary tightening is set to continue over the next year, many commentators have highlighted how well positioned the consumer seems to be for higher rates.

It is often pointed out that consumer interest rates will not be affected too much, even though Fed funds are still a long way from normal. Although there is some relationship between Fed funds and interest rates offered by banks for two-year personal loans and four-year auto loans, a return to a normal Fed funds rate might only mean a 100-150 basis point (bp) rise in these consumer rates.

Not a big deal, it seems. Even super low interest rates that auto-finance companies are offering may not be affected that much. Although zero-rate incentives have been going on for three years, the effective rate has been closer to 3% because not everybody qualifies for 0% deals.

Mortgage rates matter the most as mortgage payments make up the bulk of household liabilities. And here, Fed funds are not so important, although the expected Fed funds rate is, because most people take out a 30-year fixed rate mortgage that is linked to long rates.

According to the forward curve, further increases may be limited to about 50 bp over the next 12 months. Again, no big deal.

And even if mortgage rates were to skyrocket, who cares?

Most homeowners have fixed rate debt, so that the average mortgage rate will not rise much at all. In fact that effective mortgage rate has gone straight down for nearly three decades. Granted, the ride down may now be over, but the average rate will not be going up significantly, even if long rates rise substantially.

And now for the real bonus. Rising rates are good for the consumer because net interest income will rise, thereby pushing up disposable income. This source of increased income could stimulate spending!

Consumers receive more in interest income than they have to pay out in interest. Given that interest income is mostly tied to variable rates, while interest payments are mostly tied to fixed rates, rising rates should give a nice boost to net interest received, boosting disposable income.

Net interest received typically does get a boost in a Fed tightening period. Let us start with the impact of an extreme tightening phase.

When the Fed funds rate rose sharply from 5% to 20% between 1977 and 1981, net interest income boosted disposable income a huge 4 ppts, from 5% of disposable income to 9%.

Of course, this direct boost to income was utterly swamped by indirect effects, such as the collapse in business activity due to the sharp rise in rates. This drove the unemployment rate sharply higher and pushed demand and income into a double-dip recession.

More 'normal' tightening phases in 1988 and 1994 directly pushed up net interest income by roughly 1% of disposable income.

Despite this, the indirect effects of rising rates still managed to produce a recession in 1990 and a slowdown in 1995, which in both instances were associated with Fed easing.

The 1999/2000 tightening, in contrast, did not produce a rise in net interest income as the pick-up in interest payments outstripped the rise in interest received. The culprit seems to be the ever rising debt-income ratio, which acts to raise interest payments relative to what would otherwise be the case.

Debt servicing as a proportion of income is still near record highs, despite record low interest rates last year. This is a hint that future tightening may not boost net interest income by very much, given debt has soared even higher since.

The analysis of the direct impact of rate rises on the consumer concludes that things look pretty good. Unfortunately, what it fails to consider fully is the indirect effects that we have already hinted at.

Although net interest received is boosted in Fed tightening periods, it is well understood by economists that the propensity to spend by interest payers is higher than that of net interest receivers. This limits the flow through of higher income to consumption.

Moreover, higher rates raises the hurdle rate for investment, which results in some activities being postponed, and therefore sets off a chain reaction which acts to cool business investment, output, employment, disposable income and therefore consumption.

Rate changes affect the appetite for debt. Low rates in recent years have fuelled borrowing, which is then spent, whereas a rise in rates will slow borrowing, thereby slowing spending.

This effect will swamp any rise in net interest income and could even offset the stimulus coming from a decent rise in employment.

Some serious employment and wage growth would be required to offset this drop in debt growth. The portion of slower debt growth that would hit consumption quickly is lower mortgage equity withdrawal.

In the recent recession, consumption was robust despite 2.7 million job losses. This suggests the exact opposite might soon apply - good employment with weak consumption.

Weak consumption could then have a negative second round impact on employment, particularly if employment is a true lagging indicator.

The icing on the consumer bear cake is that the vulnerable nature of the consumer debt binge is reflected in the US household sector being a net borrower. Typically, the household sector in aggregate is a net saver. And this is the way an economy normally works.

The stock market bubble of the late 1990s had a lot to do with this, as the illusion of untold riches from equities gave many people little incentive to save from current income. But when the stock market bubble burst, it should have acted to push the household sector back up to its default net-saver mode. But it did not.

Why? The rise in housing wealth is the prime suspect.

Our economists' own view is that the housing market is a bubble, and as the party stops by mid-2005, households will have to save the old-fashioned way once again, from current income, rather than betting on asset inflation.

This report has been compiled by HSBC Bank Malta plc on the basis of economic research carried out by HSBC International Bank's team of economists and financial analysts.