Although the Federal Reserve has said that it will leave the door open for more interest rate hikes should rampant inflation revive, the interest rate tightening cycle is nearly complete. The rampant inflation factor in the economy has been checked for now, but how soon will interest rates be reduced?
Too Low Too Long: Since the last period of serious inflation that ended in the early 1980’s, the U.S. economy has enjoyed an era of steadily declining and continuously low interest rates. Then in the early 2000’s, the dotcom boom played out, and interest rates went down to an ultra-low point in an effort to create a soft landing. Interest rates remained ultra-low for a substantial amount of time, and when tightening did begin, rates went up very slowly. This led to asset bubbles and the financial crisis of 2007/8. Not only was the Fed accommodative of lower interest rates in loans to banks, but also provided substantial quantitative easing (QE) or increases to the money supply. This low interest rate/high money supply environment got to be commonplace to the extent that even slight reductions to the amount of additional QE would cause some market upheaval.
A Resilient American Consumer: Since the covid-19 pandemic of 2020, the American consumer has been awash with excess savings owing to lockdowns and stimulus payments. After the covid-19 crisis lifted, inflation began to rage forcing more savings upon consumers who were reluctant to spend due to the uncertainty that inflation can bring to the economy. This uncertainty was magnified when consumers were faced with purchasing large ticket items such as automobiles, furniture, houses, and vacations. The reluctance to spend on the part of consumers can be quantified to date in aggregate as perhaps $1 trillion in excess savings or about 5% of annual personal income. This excess savings may start a money flow pouring back into the economy when prices throughout appear to stabilize. When that happens, it will continue to bolster economic growth that reached 4.9% of GDP in the third quarter of 2023.
Corporate Debt Is Stable: Since rates have been so low for so long, many major corporations loaded up with low interest debt. Much of this debt will not be due very soon and perhaps will not be refinanced into the current higher rates. The 16% of overall corporate debt that likely will be refinanced will only bring the aggregate interest rate for the debt class up 0.3% to 4.5% by 2025. Smaller companies may have a greater proportion of their debt come due sooner, however, putting them in more of a bind trying to refinance this debt if interest rates don’t recede any time soon. The longer that interest rates remain high becomes the greater the risk to corporations of all sizes that their costs of capital will rise regardless of how it is currently structured.
Homeowners Will Remain Locked In: Many homeowners were able to lock in lower rates during recent years especially toward the end of the pandemic. This made the housing market buoyant with steadily higher prices, but still left buyers with affordable mortgage payments. However, should the need arise for these well positioned homeowners to sell their property, the value of their homes will likely fall as new buyers will be fewer and farther between when faced with higher interest rates and higher monthly payments. Should current interest rates hold at the same level until the end of 2025, the decline in home prices from 2022, when the Fed tightening cycle began, could be in excess of 35%. That would mean that current homeowners would be faced with declining values for their houses in excess of one third of their original cost owing just to high interest rates.
How Are the Banks Holding Up? Rising interest rates can create apprehension for bankers. On the one hand, they are able to raise rates for loans to their customers, but on the other hand, they must pay more for the capital they get from depositors and other banks including the Fed. Further, many banks own large amounts of government bonds that are secure, but these investments are also at lower rates lowering their asset value thereby pinching the bank’s capital reserves and collateral for future loans. Much of the decline in assets held by banks is not recorded as a loss since it’s considered to be transitory. In some instances, the Fed will loosen the rule of recognizing losses and lend to banks at the face value of their government bonds rather than the market value which could be lower.
How is Commercial Real Estate Holding Up? Commercial real estate is faced with a double-edged sword: rising interest rates for refinancing debt, and declining rents owing to an increasing number of office workers who now work from home. The lending to commercial real estate has drifted from banks to other financial institutions such as pension funds, mutual funds, insurance companies, and other shadow banking organizations. Some of these organizations have never had to deal with the specter of sharply increasing interest rates before, since rates have been even keeled for such a long time. The dispersal of risks will help banking in the long run, but it could also place a larger number of lending institutions in financial trouble.
Can Growth Run Faster Than Debt? If a country’s economy can grow faster than its debt grows, it will show a decrease in its debt-to-GDP ratio. But this race should be a sprint and not a marathon—much of the world’s fiscal debt is as high versus GDP as it has been at any time since World War II. We can expect massive government debt during a major war or other catastrophe, but why should it occur during the ordinary course of business during normal years? Reducing the debt can only be done via cutting costs and increasing taxes—two things that elected governments rarely do, especially with an election coming up inside of a year. Further, the economic consequences of either cutting costs or increasing taxes will have a negative impact on the GDP side of the equation.
What Brings Down High Interest Rates? Inflation will reach a pinnacle at some point and stop rising. This would be the signal that interest rate increases would have done their job and would no longer be necessary. When this happens, a great concern among economists arises that prices could start to fall uncontrollably causing deflation, the opposite effect of inflation. Deflation is far worse and much more difficult to deal with as economic growth could stop in its tracks. Worker incentive will be destroyed during deflation as the average wage earning or salaried employee would receive a pay cut each year instead of a pay increase. Unions would strike all over the economic spectrum further damaging growth. Another way to bring down high rates would be to observe that the economy is not growing at all and is heading into a recession. Central banks including the Federal Reserve would then begin to reduce interest rates to combat the declining growth.
Conclusions: Careful navigating of the economy is needed when interest rates peak. Cut them too soon, and inflation may start up again. Cut them too late, and the risk of deflation grows. The economy runs smoother when growth runs faster than debt, but trimming of government budgets is also needed. No one can expect that the GDP in a healthy market economy will continue going up forever. The process of cooling off the economy without freezing it up or rekindling inflation will likely mean that interest rates will remain high and will recede slowly as the rate of inflation slows itself back down to its 2% target. This could involve a process that will likely take several years.
Sources: Interest Rates and the World Economy, The Economist, November 4th, 2023.