As interest rates rise, will borrower prudence, too?
| Washington and Boston
Like a small cloud on a sunny beach, a quarter-point hike in short-term borrowing rates arrived over the economy Wednesday.
The beachgoers are unlikely to notice. The Federal Reserve has already jacked up rates and the pace of economic growth has risen not fallen. The stock and housing markets are doing splendidly. Consumer confidence is at a post-2000 high and rising.
The interest-rate horizon has been sunny for so long 鈥� nearly a decade, in fact 鈥� that Americans may have forgotten what happens when interest rates rise. But with more rate hikes predicted for next year after a full percentage point rise since last December聽鈥� the fastest jump since 2006 鈥� it鈥檚 time for consumers and investors to adjust their thinking to a new reality.
Among the likely impacts of the new period:
- Credit-card rates will rise, at a time when credit-card debt has rebounded from the Great Recession to reach record levels again and some borrowers are already showing signs of stress.
- Some holders of student debt, those who took variable-rate loans as well as students taking out new loans, will take a hit.
- Rates on auto loans and even mortgages are predicted to go up, albeit more slowly than more short-term debt. Auto loan delinquencies are on the rise.
- Savings or money-market accounts may finally start offering interest rates that come close to matching inflation. But the stock market could grow more volatile.
What鈥檚 needed in this period or rising rates is not panic but prudence, economists and consumer-finance experts say.
鈥淐onsumers and investors both have the first instinct of protecting and maximizing their assets,鈥� Jill Gonzalez, an analyst at consumer-finance website WalletHub, writes in an email. 鈥淭his means that if interest rates go up, consumers will increase their savings since they can receive higher rates of return, and investors will be more inclined towards maintaining a diversified portfolio to counteract the volatility over time."
Of course, interest rates have stayed so low for so long that even economists are unsure what impact the expected rate-rise will have. Borrowing costs will still be lower than historic norms. The best guess is that impacts will be muted 鈥� for both consumers and investors. The temptation to move from stocks to fixed income will be there for some, yet yields will still be nothing to write home about.
Rate hikes and recessions
But finance experts also caution against complacency. A period of Fed tightening is not just about interest rates. It鈥檚 also about how well the central bank can do at regulating the economy鈥檚 monetary spigot. Economist Gary Shilling offers a blunt outlook in a new report.
鈥淚f the Fed persists in tightening, a recession is in the cards. By our count, in 11 of 12 post-World War II attempts by the central bank to cool the economy without upsetting the apple cart, a recession resulted. The only soft landing was in the mid-1990s,鈥� Mr. Shilling writes.
For now, economists don鈥檛 see recession as a meaningful threat for next year. But some see the risk rising in 2019 if the Fed keeps tightening as expected.
All this can create uncertainty in the stock market. It鈥檚 also a reminder that the Fed鈥檚 steering of short-term rates doesn鈥檛 necessarily determine longer-term rates like those on mortgages or Treasury bonds. Marketplace forces are key. If bond-market investors are worried about a cooling economy, long-term interest rates can go down (or go up less) even when the Fed is raising interest rates.
鈥淥n average, a one percentage point rise in the [Fed鈥檚 short-term lending rate] leads to a 0.42% rise in 10-year Treasury yields,鈥� Shilling explains.
Home buyers may face an uptick in mortgage rates, but economists note that over the past year the borrowing costs on a fixed-rate mortgage have edged down even as short-term rates have risen.
Nevertheless, if prospective buyers see an upward trend in mortgage rates, that could push some into action to purchase a home before rates go higher still, says Chris Christopher, executive director of US and global economics at IHS Markit near Boston.
Others could be priced out of the housing market entirely, he adds, in areas like New York City or San Francisco where prices are very high.
A credit-card hit
One of the first places consumers will see the impact of rising rates is on their credit card statements. Since December 2015, the Fed has driven rates up a full percentage point from near zero (not counting Wednesday鈥檚 increase) and credit card rates have moved up in lockstep, according to released this week.
WalletHub estimates that those hikes cost consumers an extra $6 billion in credit-card interest this year. Wednesday鈥檚 increase will boost consumer costs another $1.46 billion in 2018, it says.
By contrast, interest rates on savings accounts and certificates of deposit have barely nudged up at all since the Fed began raising rates.
鈥淚f interest rates go up, people will come out of stocks and go into fixed-income investments,鈥� says Shawn Lesser, co-founder of Big Path Capital, a socially oriented investment bank. But the interest rate 鈥渋s so low that even if it moves up 1 percent, I don鈥檛 know how much of an impact it would have.鈥�
The Fed has had interest rates very low before.聽The effective federal funds rate (which is the actual rates banks pay each other on overnight loans) dipped below 1 percent for three months in 1954 and again in 1958. It didn鈥檛 fall that low again until 2003 for one month. But in 2008, in a bid to stave off the financial crisis, the Fed slashed it below 1 percent, where it remained for 8-陆 years.
Only in May have they edged above 1 percent. And the consensus among forecasters surveyed by the National Association for Business Economics is that interest rates will be near 2 percent by the end of 2018. That鈥檚 still low by historical standards, where the average over six decades is 4.9 percent.
Troubling signals
There are already signs of strain. Although foreclosures have receded, delinquency rates among auto finance lenders are rising, especially for subprime borrowers, the Federal Reserve Bank of New York warned in a November report. Credit card delinquencies are up over the past year. College-loan troubles have been mounting along with the debt itself.
When CompareCards.com about why they had accumulated credit-card debt, 42 percent said "making ends meet."
At some point, interest rates could get so high that consumers would have to change their spending habits.
鈥淭here certainly should be a tipping point,鈥� writes Ms. Gonzalez of WalletHub. At the start of the Great Recession 鈥渋n 2007, that was about $8,400 of credit card debt per household, which we're almost back to hitting again. However, since unemployment is at a 17-year low and consumer confidence is high, I see no signs that consumers will rein in spending any time soon."
