News in Charts: How a quicker pace of tightening by the Fed would affect the US economy

Political uncertainty may have cast a cloud over Donald Trump’s ability to loosen fiscal policy, but we still think that the FOMC will raise the fed funds rate by another 150 basis points between now and the end of next year. We estimate that this would increase the annual borrowing costs of businesses and households by nearly $150 billion. To the extent that this tips unproductive firms out of business, it would ultimately be beneficial for the economy. But, in aggregate, US households and corporates have improved their balance sheets and many have locked in low borrowing costs for the foreseeable future, immunising them from higher interest expense, for now. We also expect wages and inflation to rise significantly over the next few years, meaning that real interest rates will remain low for some time. Against this backdrop we think that economic growth will accelerate.

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The health of the US corporate sector has been repeatedly questioned by analysts over the past few years: equity valuations look lofty; credit spreads are low; debt is close to its all-time high as a share of GDP. In addition, the IMF recently cited higher US corporate leverage as a potential risk to global financial stability. It might seem, therefore, that US corporates are in a bad way. In aggregate though, we think that corporate sector balance sheets are, in fact, in much better shape now than they were in the past.

Corporate sector debt may be close to an all-time high as a share of GDP, but the corporate sector is a larger part of the economy now than it has been in the past, a point reflected in the high level of profits relative to GDP, illustrated by the chart below.

Even though some firms have faced headwinds such as a stronger dollar, higher wage costs and lower oil prices in recent years, corporate profits remain solid. Indeed, the ratio of corporate debt to profitability is much lower now than it has been in the past, and if the corporate tax rate were slashed from 35% to 15%, as proposed by Donald Trump, after-tax profits would rise significantly.

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The IMF may have flagged the risks posed by the US corporate sector in its recent financial stability report, but this warning was linked to a hypothetical scenario in which risk-taking increased in response to changes in the fiscal policy of the US government. The very same report noted that, in aggregate, US corporate sector balance sheets are strong and that proposed changes to the US tax code would encourage firms to favour equity financing over debt financing. These admissions received little coverage in the media.

A longer debt maturity profile than in the past…

An increase in the fed funds rate would increase borrowing costs, but many firms have locked in low borrowing costs by issuing long-term debt at low rates of interest. Short-term debt as a share of total debt is close to its lowest on record; the ratio of corporate bonds to total corporate debt is close to an all-time high (at around 60%); and the average duration of US corporate bonds is more than seven years. For firms rolling over debt, it will typically be many years before any further pick-up in corporate yields feeds through to higher borrowing costs.

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… but not all firms will be immune to higher rates

We have long argued that higher interest rates are the medicine that the economy needs to address its productivity problem.

We may have seen how, in aggregate, corporates are more profitable than they were in the past and rely less on short-term floating rate financing than they once did. But not all firms have wide profit margins, and not all firms have locked in low borrowing costs for the foreseeable future. There will be some firms that are more sensitive to higher rates than others. To the extent that higher interest rates push the unproductive ones out of business, this would ultimately be positive for the economy.

Non-corporate businesses would feel the pinch

The US national accounts split the non-financial business sector into corporate businesses and non-corporate businesses. The data presented thus far considers only the former. The latter consists of partnerships and limited liability companies, which are owned by households.

The distinction may sound trivial, but in the national income and product accounts (NIPA) the consumption of non-corporate businesses is included as part of personal consumption expenditures (PCE), and their income is part of personal income and thus feeds into household saving. Since these firms are small and have less access to capital markets (and less ability to issue long-term bonds), they would feel the pinch from a higher fed funds rate a lot sooner than corporate businesses, assuming that a large share of this debt is floating.

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Households have less debt and save more

Overall though, the household sector is better placed to withstand a rise in interest rates now than it was in the past. For a start, household sector debt is a lot lower than it was ten years ago, both as a share of GDP and as a share of disposable income. This remains the case when non-financial, non-corporate business debt is included in household sector debt.

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Moreover, the personal savings ratio is higher than it was before the 2008 crash and the debt servicing ratio is close to an all-time low. In other words, households are saving more than they did, while debt repayment is less of a burden on household finances than it was in the past.

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Significantly, the cost of servicing debt has not been very sensitive to changes in short-term or long-term interest rates in the past. Mortgage default rates have not been very sensitive to changes in borrowing costs either. The most plausible explanation for this is that unlike most other countries, mortgages issued in the US are generally issued with fixed rates of interest for 30 years.

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According to data from the New York Fed’s Quarterly Report on Household Debt and Credit, released last week, mortgages account for around 70% of total household sector debt. Auto loans and student debt have risen significantly over the last few years, but these loans are issued with fixed interest rates and make up just one fifth of total household sector debt combined.

Interest rates on credit card loans, which are sensitive to changes in the fed funds rate, represent a declining share of household sector debt, and account for just 6% of the total. In other words, the vast majority of household debt in the US is issued at fixed rates of interest.

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Admittedly, in the run up to the subprime crisis, around a third of new loans were issued with floating rates of interest, also known as adjustable rate mortgages (ARMs). Some of these loans had features that included low fixed rates of interest for an introductory period and then switched to higher variable rates of interest at a later stage. But these loans are a lot less common than they were and lending standards have significantly improved since 2008.

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ARMs now account for less than 10% of all mortgages originated, much lower than during the peak of the subprime lending. The upshot is that households are even less sensitive to changes in interest rates than they were in the past.

Many households have also locked in low borrowing costs after refinancing their 30-year mortgages at very low rates of interest over the last few years.

How much would it all cost?

Using the aforementioned information we have estimated the direct costs associated with a 150 basis point increase in the fed funds rate, assuming that such an increase was fully passed on to households and businesses. We have also assumed that all non-corporate business debt is short-term and subject to floating rates.

Based on these assumptions, we estimate that the incremental expense for non-corporate businesses would be roughly US$ 75 billion per year, 0.5% of the US$ 14 trillion in disposable income of households. The incremental expense from credit cards and mortgages would be less than US$ 26 billion per year, or 0.2% of disposable income. The borrowing costs of the corporate sector would rise by less than US$ 40 billion per annum, little more than 2% of the value of total annual after-tax corporate profits.

Admittedly, these figures do not consider the additional burden that higher interest expense would place on the public finances or the indirect costs to households and corporates. Higher interest rates would increase the cost of new investment and may deter some new investment at the margin. It would also increase the cost of moving home since, to do so, households would need to take out new mortgages at higher rates of interest. Equity prices may fall and some would be vocal in their opposition to a higher fed funds rate.

But there are ways in which higher interest rates could have a positive effect on the economy too, such as improving the efficient allocation of resources and raising its productive potential. In addition, some businesses – including banks, pension funds and insurance companies – would directly benefit from higher interest rates.

What’s the bottom line?

Overall, businesses and households are in a better shape to cope with higher interest rates now than they were in the past. Most debt held by corporates and households is fixed at low rates of interest for the foreseeable future. Even if the Fed raised the fed funds rate by 150 basis points between now and the end of next year, the direct costs to the economy would be small in the grand scheme of things.

Crucially, although we expect the Fed to raise interest rates faster than most investors do, we also think that inflation and wages will rise a lot quicker than they have done over the last few years. In real terms, we still expect the fed funds rate to remain lower than it has done in any other tightening cycle since 1971 (see chart). The FOMC also expects to raise interest rates only gradually, judging by the ‘dot plot’ and the inflation forecasts of FOMC participants. Set against a backdrop of rising wages, increased government spending and tax cuts, we expect household spending and investment to rise significantly, more than offsetting the direct and indirect costs of higher nominal interest rates.

IN HOUSE

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