- The Federal Reserve continues to hold to its mantra that it will keep U.S. interest rates low for an "extended period of time." However, that message seems to be meeting deaf ears. U.S. corporate...
Economic Research: It's Only Up From Here
The Federal Reserve continues to hold to its mantra that it will keep U.S. interest rates low for an "extended period of time." However, that message seems to be meeting deaf ears. U.S. corporations are racing ahead of what everyone knows is coming eventually: the day when the Fed will start to tighten monetary policy after nearly four years (and counting) of easy money.
Corporate America's expectations aren't unfounded. With interest rates at historic lows, the U.S. economy continuing to grow, and rising fears that inflation is lurking around the bend, it doesn't take an expert to conclude that U.S. interest rates have only one way to go: up. The questions, then, are how fast and how much? Will the upcoming moves derail the recovery and who will feel the most pain?
However and whenever the Fed acts, we don't expect its moves to derail the recovery. Although the recent shock of oil reaching $100 per barrel and the supply shock from the Japanese crisis are having a much bigger effect on economic growth, the U.S. Economic recovery still looks to be in place. Household and corporate balance sheets have improved since the financial crisis (partly at the expense of the public-sector balance sheet). Personal savings rates have increased, and corporate profit margins have widened to record highs. With private demand finally picking up, businesses have started to hire again--though only enough to keep the pace of recovery at half-speed.
With the unemployment rate stubbornly above full employment levels and the current soft patch pointing to another modest GDP figure for second-quarter 2011, the Fed will likely tread carefully with its interest-rate moves, giving the economy more time to heal. At Standard & Poor's, we expect the Fed to only start increasing interest rates by early 2012 and to continue to do so through 2014 until they reach 4.0% by year-end. Higher rates will increase borrowing costs in the U.S. and slow down growth, since the better returns from higher interest rates for cash-rich investors would only partially offset the slow down.
Some groups will be at risk once the Fed takes the air out of the economy's sails. The still-fragile housing sector will likely be the first to feel the effects of higher interest rates. Debt-poor consumers will cut back on spending as they attempt to cover their higher debt charges. Businesses that are losing revenue will reduce hiring, which will further slow down growth.
The baseline forecast is for a gradual increase in interest rates. But there are risks to this outlook. Even if the Fed raises rates in baby steps, long-term rates could climb more quickly than expected over worries that inflation will climb higher or that the government cannot manage its massive debt.
As Low As We Can Go
Any increases will be relative, of course. Over the past few years, the Fed has lowered the federal-funds rate to nearly zero--the lowest it can go--in hopes of spurring lending. Even that wasn't enough to stimulate consumer spending and raise employment rate. So the Fed followed with an alphabet soup of measures aimed at boosting liquidity in the economy, plus new insurance programs, which aimed to help calm investor fears. These strategies helped spur private demand that had all but dried up. By the spring of 2009, the financial markets had started to heal.
In the process of engineering a steady, although painfully slow U.S. recovery, the Fed flooded markets with liquidity, and created a $2.86 billion balance sheet that needs to be unwound at some point. Everyone is wondering when the Fed will initiate its exit from easy money, how fast the withdrawal pace will be, and what the effect on growth might be.
Although a few members of the Federal Open Market Committee (FOMC) had expressed concern over the current loose monetary policy, the recent economic slowdown kept the Fed on the side-lines at the FOMC meeting in June, and the Fed continues to hold back on tightening, keeping the federal funds rate between 0% and 0.25%. The discount rate is set at 0.75% and is below the historical spread from the federal funds rate.
In fact, no one dissented from that position at the June FOMC meeting. The Fed continues to label inflation in the economy as transitory and unemployment as elevated. At the post-meeting news conference, Fed Chairman Ben Bernanke, while not calling inflation a long-term concern of the Fed, did call it distressing for consumers.
The upshot is that the Fed does seem to be thinking about when to begin raising rates. Its recent decision to stop buying long-term Treasury debt, while reinvesting as the notes mature to keep its portfolio level, signalled a revisiting of its easy policy at the next meeting. However, Mr Bernanke's statement on June 22 that the Fed doesn't "have a precise read on why this slower pace of growth is persisting," sounds like the Fed's "transitory" mantra is running thin. The Fed expects the economy to settle into a disappointing recovery and seems to believe that it has done all that it can do, for now. Mr Bernanke reiterated that no new quantitative easing program, or QE3, is in the works.
At the April FOMC meeting, members extensively discussed their stimulus plan exit strategy, according to the meeting minutes. There has been some internal debate at the Fed about raising the discount rate to 1.25% to maintain the traditional one percentage point spread over the Fed funds rate. If that happens, consumers would likely be lightly affected because the prime rate would probably remain at 3.25%. But it would be viewed as a precursor to a Fed-rate increase.
We expect that the Fed will move slowly in tightening policy rates for several reasons. Unemployment rates are high, and wages are sluggish. With industrial companies still operating at low capacity rates, growth will likely remain slow through next year, with inflation (excluding energy and food) staying soft.
When the Fed eventually raises nominal interest rates, the increases will likely lag behind the increase in inflation. In short, monetary and fiscal conditions, like the rest of the world, will continue to be easy and should make the recovery resilient for now.
Why So Slow?
Some observers think policy should soon shift from easing to tightening to ward off inflation. But with the U.S. economy hitting a few bumps along the road to recovery, we expect that the Fed won't overact. GDP grew a tepid 1.9% in first-quarter 2011. In our opinion, that means low interest rates are still needed to spur growth.
Indeed, although growth has been positive for seven consecutive quarters, the increases are getting smaller. The pace of recovery remains significantly slower than in previous economic recoveries. The main reason is the unemployment rate, which stubbornly refuses to subside. Even the 2.6% growth rate expected for 2011 won't be enough to make much of a dent in unemployment. It would take 4% growth for a full year to lower the unemployment rate (now 9.1%) by just one percentage point.
It is expected that it might take five or six years before unemployment falls to a more typical range of 5% to 6%. We also expect that about 1.6 million jobs will be created this year, which is good, but not good enough to quickly recover the 8.7 million jobs lost during the recession. In this less-than-stellar environment, the Fed won't make even a tiny step to tighten rates until the unemployment rate falls to around 8.5%.
Soft job growth in May, with key economic indicators weak through mid-June, increased worries that the economy is faltering. The net increase of 54,000 jobs in the month was one-third of the 150,000 new jobs the market had expected. While we now have a 15-month string of job gains, with the three months ending in April reporting outsized jobs gains, the pace will hardly put a dent in the ranks of the 14 million people who are still out of work.
Unfortunately, the jobless rate isn't likely to fall much lower this year because discouraged workers who lost their jobs and quit looking for work might now see hiring on the upswing and will try to re-enter the labour force. A rising number of active job seekers will help keep the unemployment rate elevated, even as more jobs are created and more people are hired.
As for whether keeping rates low threatens to cause inflation, data continue to indicate that, excluding food and fuel, inflation is tame. Wage gains remain subdued, with average hourly earnings up just 1.8% from last year. With unemployment high and wage gains likely subdued through the year, consumers will remain cautious. Even though more companies are trying to pass along at least some of their higher costs for raw materials, including commodities, to consumers, they won't gain much traction.
Still, consumers might feel the overall increase in consumer prices more pronounced than the figures the Bureau of Labour Statistics (BLS) reports. The BLS measures a large sample basket that covers much more than just food and gasoline purchases. For example, the drop in the prices of apparel and telephone services, which make up about 6% of all spending, largely offset the rise in cost of food away from home, which also makes up 6% of consumer purchases.
What Comes Down, Must Eventually Go…
And even if the spike in commodity prices is "transitory," as the Fed continues to believe, and not yet a threat to inflation, there are signs that the Fed shouldn't feel too comfortable keeping interest rates at near-zero levels too long. Rents are creeping up, for example. During the past few years, declining rents have held down the housing cost component of the consumer price index (CPI), offsetting increases elsewhere. Rents are a major part of the core CPI index, excluding food and energy, which the Fed watches closely for long-term inflation trends. An increase in rents would push core CPI to uncomfortable highs and force the Fed's hand. We look for core CPI to increase about 1.5% this year up from last year's 1.0% rate.
Such a shift is sure to come as a shock to consumers whose spending habits were shaped by a historic, 30-year decline in the cost of borrowing that began in 1981. The expected increase in rates will still be very low by historical standards, with our 3.3% rate for 2011 barely one-third the 16% yield for 10-year Treasury notes in 1981. However, the steadily dropping interest rates also left Americans with excessive borrowing habits, as they spent more and more but managed to hold down the portion of their income devoted to paying off loans.
Total household debt is now nine times what it was in 1981, while the amount of disposable income that goes toward covering that debt has budged only slightly, increasing to 11.5% in first-quarter 2011 from 10.7 % in 1981. Household debt has been dropping during the past two years as recession-battered consumers cut back on borrowing, but it still exceeds disposable income by around 120%.
The psychological fallout from not being able to buy more while paying less has hit consumers hard. Americans assumed that the roller coaster goes one way, which was a thrill as rates descended. But now that they face an extended climb, some will be squeezed with higher debt costs, which, if dramatic, could reverse the direction of the recovery. Higher interest rates will push up mortgage costs and reduce housing demand, while squeezing borrowers with adjustable-rate mortgages (ARMs), which are set to go higher. Higher credit card interest rates will cut into spending by consumers who've already been hit by higher energy costs.
The housing market, which only recently began to rebound, will likely feel the effects of higher interest rates. Mortgage rates will likely increase; with that, we could see a reversal of gains in the housing market. Each 1% increase in rates adds as much as 19% to the total cost of a home. Demand dries up as fewer people are able to purchase. Fears of buying a home that could lose its value might once again resurface and add further downward pressure on housing demand.
Homes bought with ARMs will face higher monthly mortgage-rate payments down the road. The ARM-share of total mortgages has dropped significantly from its 36% peak in October 2004. Millions of foreclosures later, that type of mortgage accounted for only 2% of mortgages by January 2009. Although ARMs have climbed higher to about 6% in June, they still compose a relatively small share of total mortgages, and are thus likely to do less damage when interest rates increase this time around.
Another area in which higher rates are likely to affect consumers is credit card use. The Fed reported that the average interest rate on credit cards reached 14.26% in February 2010, the highest average since 2001. It has since come down, but it is still well above the 12% seen when rates bottomed in fourth-quarter 2008, and adds about $200 more a year in interest payments for the typical American household. Similarly, many car loans have already become significantly more expensive, with rates at auto finance companies rising to 4.73% early this year from 3.26% in December 2009, according to the Fed. Historically, households that carry a larger balance from month to month are more at risk of default.
Although higher interest rates will boost interest revenues, they will weigh on the stock market. The long decline in rates earlier helped prop up the market because lower rates for investments like bonds make stocks more attractive. That tailwind, which prevented even worse economic pain during the recession, has finally subsided, though the improved economic environment will help offset that.
The income effects of higher interest-rates don't work in only one direction. Households in aggregate also have large cash deposits, and higher interest rates raise the income earned on them. Higher interest rates increase income for people with cash in the bank and also bring money back to the U.S. from international investors who left when returns weren't so attractive.
A rate increase would also strengthen the dollar as money flows back into the U.S. in search of higher returns. The stronger dollar would weaken exports, which have only recently gained strength. An increase in the rate of borrowing would make U.S. exporters less competitive in the international marketplace and could hurt economic-growth prospects from international trade.
What Could Go Wrong
Although it is expected that the Fed will keep a cautious course in raising interest rates, things could go wrong. We worry not only about inflation fears set off by the strengthening economy, but also that a huge supply of new debt issued to finance the government's budget deficit would overwhelm demand and drive interest rates on Treasuries higher.
Washington is expecting to have to pay more to borrow the money it needs to operate. We expect the benchmark 10-year U.S. Treasury note to climb to 3.4% by year-end 2011 and to 4.5% by late 2012. But if Congress cannot reach an agreement on how to manage the debt, the results would be disastrous worldwide. Interest rates would jump for new bonds, as they have in Greece, Portugal, and other heavily indebted nations. An increase in rates would put a halt to the fragile recovery by choking off credit to businesses and households.
Assuming that doesn't happen, global inflation is the ultimate worry down the road. All one can is to continue to worry about the upward effect on inflation if tensions increase in the Middle East and push oil prices past the critical $150 threshold level, or if inflation from emerging economies is exported into mature economies through more expensive exports. The Fed's cautious steps could pave the way for imported inflation, ultimately risking a spurt in domestic prices.
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