On March 15th, the Federal Reserve raised its benchmark overnight lending rate a quarter point to a range of 0.75%-1.0%. The increase, together with a 0.25% bump last December, represents quite a shift. With a few brief exceptions, interest rates have been on a downward path since 1980.
Markets have taken the Fed’s latest effort to prevent the economy from overheating in stride. Global stock markets have generally treaded water while bonds have rallied. For many, the increase is welcome. Savers, who have long earned nothing on cash, will be relieved to finally see even small amounts of interest show up on their monthly brokerage statements.
But further rate increases will be particularly concerning to the nation’s growing ranks of borrowers. Take a look at the chart below. Since 2008, mortgage debt levels have fallen but overall personal debt has soared. Just this month, U.S. credit card balances broke through the $1 trillion level to the highest point since January 2009. Auto and student loan debt totals are each already well beyond the $1 trillion mark. Many borrowers will barely notice the latest rate increase but for those with large balances, even small rate hikes can have a big impact on monthly debt payments.
To date, a strong job market and modest wage gains have helped consumers handle the growing bills. Credit card, mortgage and auto loan delinquency rates have fallen since early 2010. But the growing level of soured student loans and a recent uptick in credit card and auto loan delinquency rates has many concerned.
For the federal government, higher interest rates also translate into increased borrowing costs. The Congressional Budget Office currently projects that net interest payments will more than double over the next 10 years to $712 billion. By 2028, it estimates that interest payments will represent the third largest category of federal spending after Social Security and Medicare. On their current trajectory, growing interest costs are likely to crowd out public spending on R&D, infrastructure and education – categories that could spur future economic growth.
The impact of higher rates on stock prices is more mixed. Higher rates, by themselves, have a dampening impact on consumer spending and corporate profits – key drivers of stock returns. Higher rates can also pull money out of stocks as bond returns become relatively more attractive. But higher interest rates also tend to occur during periods of strong economic activity, a condition that is generally supportive of stock prices. While exact predictions are difficult, research does suggest that interest rate increases are particularly damaging to stock prices when yields are already relatively high, a condition that does not exist today.
To date, the Fed has taken a very measured approach to increasing rates. This caution should allay concerns that overly aggressive actions will choke off an economic recovery. Further, the U.S. economy appears on solid footing today; labor markets and consumer confidence measures are strong and inflation is under control. But macroeconomic policy is more art than science and given the high level of debt outstanding, the risks associated with a policy misstep are higher than they have been in the past.
