Consumer Credit at All-Time High: What Does This Mean for the Fed Chair Race?

Consumer credit as a percent of disposable income is at an all-time high. What could the policies of John Taylor and Jerome Powell mean for consumers?

Americans have been tapping into credit at levels we’ve never seen before. Some of the faster growing types of credit, like credit cards and student loans, float with interest rates. This means that more Federal Reserve rate hikes could make it harder for households to pay off debt. However, we might not see a wave of defaults that we’d expect in these circumstances.

That’s according to Wells Fargo’s Chief Economist John Sivlia and analyst Harry Pershing. In a weekly interest rate research note released on October 25th (link here), Silvia and Pershing note that consumer credit is at an all-time high compared to disposable income. That would normally bring about fears of a coming crisis, as a wave of defaults could push the U.S. economy right back into recession.

However, the authors argue that the Fed will raise interest rates slower than incomes will rise. That would mean consumers would pay more on debt, but it would be less of a burden compared to incomes.

Household debt delinquencies have mostly been falling since the Financial Crisis of 2008-09. Even though consumers are taking on more debt as a percent of income, they are still paying it down and not defaulting. Steady economic growth and a continuously improving labor market are certainly making consumers feel better about their debt burdens. The only way we’d see a spike in defaults is if rates rise much faster than expected.

What does this mean for the Federal Reserve Chair race?

Jerome Powell and John Taylor are the front-runners at this point. Powell would represent a continuation of current Fed policy, while Taylor is a bit more of a wild card.

Taylor’s famous Taylor Rule formulates the proper level of Fed base interest rates. It currently stands at about 3.0 percent. This is sharply higher than the current level of 1.25 percent. A move this big would be a huge shock to consumers holding floating rate debt.

Not everyone is convinced a Taylor Fed would raise interest rates this much, though. Taylor recently argued that the economy could withstand a 3 percent growth rate without too much inflation (specifically, if tax cuts lead to GDP growth). That would be a reason to leave rates lower.

Yellen, on the other hand, thinks inflation will tick upward if a massive tax package is passed. She would likely opt to raise rates in this scenario. Countering prevailing opinion, rates could be higher in a Yellen/Powell Fed than a Taylor Fed.

Consumers have benefited from a steady and predictable economy over the past decade. A massive shift in monetary policy could be the trigger that upends this consumer confidence, which makes this Fed horse race so intriguing.

Spot Exchanges Shorts: The Apprentice: Federal Reserve Edition

(Update) Weekly Wrap: Inflation is the New Jobs Report

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Welcome to the 11th edition of the Weekly Wrap, where we love all economic data points equally, as if they were our own children.

Inflation: More Important than Jobs Data?

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Update: 9am ET

A weak CPI reading. Core CPI for September was released, and came in at 1.7 percent, 0.1 percent lower than expected. Traders are now predicting an 82 percent chance for a December rate hike, down from 86 percent earlier this morning.

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At 8:30 am (ET) this morning, we’ll get to see the updated Consumer Price Index (CPI) inflation number for September. The monthly jobs report has traditionally been the granddaddy of economic data. But this monthly inflation metric might be the new king of the heap.

• The Fed has a dual mandate: full employment and stable prices. Even with the hiccup in the September jobs report (-55,000 net jobs, the first monthly decline since 2010), the economy is pretty close to full employment.

• The stable prices mandate? That’s a different story. We’ve written about this several times recently (See: The Janet Yellen Paradox: When Raising Rates Doesn’t Equal Tighter Fiscal Conditions). Inflation has been persistently below the Fed’s 2 percent benchmark for years. Inflation, measured by CPI, has averaged 1.75 percent over the past 10 years.

• Low inflation has is the biggest source of disagreement within the central bank, according to the minutes from the September Fed meeting. Inflation was mentioned 90 times in the discussions. That’s more than 3x the number of mentions of “labor.”

Does this mean the Fed will hike rates in December?

According to the market, the answer is a resounding yes. Traders are pricing in an 86 percent chance of a rate hike in December. That’s up from about 70 percent on October 2 and 42 percent on August 18.

That’s in spite of the apprehensions of some Fed statements. Some members of the committee “noted that, in light of the uncertainty around their outlook for inflation, their decision on whether to take such a policy action would depend importantly on whether the economic data in coming months increased their confidence that inflation was moving up toward the Committee’s objective.”

Which brings us back to this morning’s CPI report. Would the Fed hold off on a December rate hike with low inflation readings? Probably not – low inflation hasn’t stopped the Fed from increasing rates before. But it is clear that monetary policymakers are keeping a much closer eye on the inflation side of the dual mandate.

What We Wrote This Week

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Other Links and Notes

Conor Sen argues in Bloomberg View that we should look past inflation – housing is the real crisis. (Don’t Worry About Inflation. Solve the Housing Shortage.;Conor Sen, Bloomberg View)

• “The more responsive approach would be to make it easier to build houses, to get public sector employers out of their recession-era mindsets to hire and pay more, and more generally, to ensure that millennial family needs are met by the public and private sector. The way to resolve a supply shortage in this case should mean creating more supply. Rather than hiking interest rates, the federal government should find ways to add construction workers, perhaps via worker training programs or immigration reform.”

Yanis Varoufakis, everyone’s favorite finance minister, argues that we shouldn’t let the Catalonia crisis go to waste. (Spain’s Crisis is Europe’s Opportunity; Yanis Varoufakis, Project Syndicate)

• “The Catalonia crisis is a strong hint from history that Europe needs to develop a new type of sovereignty, one that strengthens cities and regions, dissolves national particularism, and upholds democratic norms… But the longer-term beneficiary of this new type of sovereignty would be Europe as a whole. Imagining a pan-European democracy is the prerequisite for imagining a Europe worth saving.”

Workers quitting their jobs to seek out better ones. Could this be what’s holding back wage growth? (Record Job Openings Aren’t Enticing Workers to Quit; Eric Morath, Wall Street Journal Real-Time Economics)

• “The unwillingness to quit could be a factor holding back better wage growth, reflecting workers’ relative lack of bargaining power. It might also suggest other factors—such as the unwillingness to move for work, or satisfaction with work-life balance—is keeping workers in their jobs despite ample opportunities elsewhere.”

Cover photo: Brookings Institution (Flickr Commons)

The Janet Yellen Paradox: When Raising Rates Doesn’t Equal Tighter Financial Conditions

Janet Yellen has a decision of consequence to make. In December, the Federal Reserve is expected to raise its benchmark interest rate another quarter of a point. This would be the fifth rate hike since December 2015, when the Fed Funds rate sat at 0 percent.

First, let’s talk about the mechanics of the Fed’s interest rate policy

The Fed raises interest rates to respond to a booming economy. As unemployment falls, a virtuous cycle is sparked. With more jobs, people buy more homes and consume more goods and services. That means prices rise (well, this is supposed to happen, according to the Phillips Curve. More on that below.), which forces employers to give further raises. As it becomes more expensive to hire human labor, companies are incentivized to invest in new capital and machines to increase efficiency. This boom in wages and investment creates more inflationary pressure.

The backstop to this inflationary spiral? The Fed’s interest rate policy. Higher interest rates are supposed to quell inflation, as cash moves out of the economy and into safe assets like Treasuries. Suddenly the cost of borrowing to buy a home increases. Companies figure they can get a better return by investing their cash instead of expanding or investing in new machines. Inflation? Defeated.

The Janet Yellen Paradox

But something curious has happened over the past two years. As the Fed increases the baseline interest rate, the real (inflation-adjusted) yield on a 10-year Treasury has fallen.

The chart above shows the yield on a 10-year Treasury minus the Core Price Index, a measure of inflation.

It would be one thing if the real 10-year rate has fallen because high inflation was chopped down to size. But that’s not the case – inflation is low, and has remained low, for years. The driver of the recent trend? Investors continue to pack into Treasuries, even with falling real returns.

Think of it like this. If the idea in December 2015 was to make it more expensive to buy a home or borrow to expand a business, that goal has failed. Instead, it’s cheaper – the real interest rate is about 0.7 percent lower now than it was then.

So one of two things is happening. Either the Fed’s policy has worked too well, and we are at a point where the central bank should be loosening policy. Or the market is out of sync with the Fed’s policy maneuvers.

What does this mean for the December rate decision?

As of August 2017, the CPI showed that prices rose 1.9 percent over the past year. This is close to, but still below, the Fed’s 2 percent target. That 2 percent benchmark is also supposed to be an average.

However, inflation has been persistently below that level for years. This is where the the aforementioned Phillips Curve has broken down. Employment has been strong, but inflation remains muted. Inflation could pop up if the labor market trends in the same direction, but nobody knows if or when that will happen.

The Fed has been hawkish, and hasn’t waited around to see when the Phillips Curve reemerges. The central bank continues to raise rates, in spite of the non-inflationary indicators.

The markets are pricing in a 71 percent chance of a hike in December. On one hand, the Fed hasn’t met its target, and raising the Fed Funds rate will only put downward pressure on already low inflation. Many analysts argue that the Fed should instead hold pat and let inflation “run hot.”

But on the other hand, Janet Yellen isn’t likely to be at the Fed past February. According to PredictIt, bettors are giving Yellen a 20 percent chance of remaining the Chair of the Federal Reserve past February. Current Fed Governor Jerome Powell (29 percent) and former Fed Governor Kevin Warsh (25 percent) are currently in the lead.

The tenuousness of Yellen’s position could play into the decision. If she and the FOMC decide to hike rates, it’s easy to cut rates in the future if needed. Staying at the current level means the policy rate is closer to 0 percent, the zero-lower bound in Fed-speak.

Takeaway: By raising rates, the current Fed chair is giving a future Fed chair (maybe even her own future self) more optionality. That’s incredibly valuable in central banking. But if inflation is persistently below the target, and rate hikes aren’t pushing the market in the desired direction, might the Fed Funds rate be back where it is now anyway?

 

Cover photo: International Monetary Fund (Flickr Commons)

This Week’s Federal Reserve Meeting: Nightmares of the Taper Tantrum Redux

It’s Fed Meeting Week!

This will be the sixth of eight meetings this year by the Federal Open Market Committee. Expectations are for the Fed to hold rates steady, but to announce an unwinding of its balance sheet.

As a bit of history, the Fed used its balance sheet as a tourniquet during the Financial Crisis in order to stop the economic bleeding. Assets jumped from about $875 billion in 2007 to about $4.4 trillion now.

The Fed will likely begin unwinding these assets and shrinking its balance sheet, by letting some bonds mature and selling others back into the market. The idea is that the economy is in a more solid place today, so the Fed can move past the post-Crisis emergency monetary policy measures.

There is still a potential problem: this is uncharted territory. The big four central banks – the Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan – all amassed giant balance sheets post-Crisis. The U.S. is the first to dip its toe into unwinding those assets, so nobody is sure what exactly will happen.

The worst case scenario is a repeat of the Taper Tantrum.

In 2013, then-Fed Chair Ben Bernanke and the FOMC spooked markets by bungling a series of statements about scaling back the Quantitative Easing program.

Markets reacted violently. Treasuries spiked as investors started dumping their holdings. The 10-year Treasury nearly doubled in the course of a few months, from 1.70 percent in April 2013 to about 3.00 percent in September. The Fed eventually got ahold of the situation, and rates fell back, but not without scaring the market for good.

Which is why rate hike probabilities have actually come down. At the beginning of the year, the markets thought the Fed would hike 4 times. Instead, we’ve had 2, with the next one possibly coming in December. Members of the Fed have stated recently that they will be cautious on rate hikes moving forward. An aggressive interest rate path could send the economy into fits.

There is one potential X-factor to all of this, however. The Federal Reserve leadership is in a state of flux. Chair Yellen might not be reappointed in February; Vice-Chair Stanley Fischer is leaving next month; two other Trump nominees for Fed board positions have yet to be confirmed. In all, only three of seven Fed seats are filled. What happens when the roster is fully-formed?

But stay focused on this week and the next few months. Like ECB head Mario Draghi once remarked, the Fed was willing to do “whatever it takes” to backstop the U.S. economy. But Janet Yellen and company will certainly tip-toe as the Fed heads for the exit.