What Consumers Can Expect From Rising Interest Rates

What Consumers Can Expect From Rising Interest Rates

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On March 21, the Federal Reserve raised its benchmark interest rate from 1.5% to 1.75%, the highest it has been since the Great Recession. It was, most likely, a big mistake.

The Federal Reserve has a dual mandate to keep employment high while keeping inflation low and relatively stable. It pegs this around a goal of approximately a 2% annual rate of inflation. Any higher and the bank generally feels like the economy is expanding too quickly. Much lower and the bank believes there’s room to grow.

The relationship between interest and inflation has to do, essentially, with employment. Low interest rates make it easier and cheaper to borrow money, causing both individuals and companies to spend more. (The Federal Reserve’s interest rate tends to influence corporate borrowing more than individual consumers, but it touches most everything.) This spending stimulates the economy, moving money that otherwise would have stagnated in bank holdings into retailers, manufacturers and service providers.

The upshot is an increase in hiring as those vendors, now flush with new customers, go out and hire workers. That makes the labor market tighter, pushing wages up as companies have to fight harder for talent, and everyone gets richer. Those workers go out and become wealthier consumers in their own right, driving more spending and creating a self-perpetuating cycle of employment, which the Federal Reserve tries to stimulate with those original low interest rates.

This drives economic growth, as factories and businesses produce more to attract this population of new customers.

But, and here’s the catch, if consumer spending power grows faster than the economy can pump out new products for them to buy, there’ll be a shift in equilibrium. Consumers will start to have more money in their pockets relative to the number of products on the shelf. Retailers will respond by increasing the price of those products. Those higher prices will lead, in turn, to higher wages, which will make for wealthier consumers and which will push prices up further. This creates inflation, which the Federal Reserve tries to quell by raising interest rates in an effort to curtail spending.

Now, historically this seesaw relationship between inflation and employment has indeed worked as advertised. So as a result of the high and steady employment rate of the past several years, the central bank has begun raising interest rates in an effort to stay ahead of this inflationary cycle.

However, a careful reader will have noticed a number of assumptions in our model, chiefly that workers will get richer as their employers do and that the consumer economy will hit peak production. It’s worked that way in the past but the economy simply isn’t working like it once did. There are new forces at play.

Chiefly, while spending has gone up in the form of GPD and stock market growth, the inflation rate has remained relatively stable. For years it has hovered at or below the Federal Reserve’s target despite stock market gains and strong baseline unemployment. The reason for this is that while the nation as a whole has gotten richer, consumers haven’t.

From a wealth creation standpoint, wage stagnation remains a problem. Further, anyone who thinks that consumers are getting too rich for the economy to handle can take a look at some of the recent household debt numbers. Consumers generally tend to prioritize debt payment when they get new money, which in and of itself creates a major drain on the modern economy as student loans capture all of the gains made by more and more young Americans. Yet even still, household  non-housing debt is on the rise. In a nation of increasingly wealthy individuals, consumer debt should arguably have plateau’d, if not begun to decrease.

It hasn’t. Americans are still leaning heavily on their credit cards, and a lot of the reason is that the employment numbers just don’t look as strong once you scratch the surface. Yes, at 4.1% unemployment, the Federal Reserve considers the nation fully employed.

However, when you include underemployment, that number jumps to approximately 8.5%. About 1 in 12 Americans can’t find a full-time job. Meanwhile, the labor force participation rate, which measures how many able bodied adults choose not to work, remains well below modern norms. Of the millions of Americans who exited the labor force during the Great Recession, shockingly few have come back.

That won’t surprise some people. Anyone who thinks the labor market is actually tight right now need only ask a millennial who didn’t major in computer science exactly how easy it is to find a well-paying job. The explosion of Uber and Lyft drivers in that cohort suggests they’ll be easy to find.

There are many theories why this is happening. Labor force participation remains a significant one, with many economists suggesting that this shadow workforce is why a low-unemployment economy is growing so similarly to a high-unemployment economy. Workers are more fungible than our headline unemployment number would suggest because so many replacements are sitting on the sidelines.

Others suggest that this is an effect of increasing corporate concentration. As individual companies grow in size and market power, they exert enormous influence to depress wages, enforce binding covenants and otherwise capture more wealth from individual workers. The term for this is “monopsony,” a market in which there is only one buyer, and it is the subject of a new paper from the Roosevelt Institute. With fewer and fewer buyers for workers’ services, those remaining companies get more power to set whatever price they want.

An inflationary cycle depends on strong consumer spending to kick it off and keep it going. Consumers have to become richer faster than the economy’s productive capacity can reasonably keep up. Yet there’s reason to believe that the economy can produce far more goods and services than it is currently, if only the consumers were there to buy them. Despite good headline numbers, those consumers seem stubbornly absent and many are spending what gains they’ve made to pay down credit card and student debt.

Growth has been struggling along, but there are many reasons to believe that it isn’t at the pace necessary to kick off a true inflationary cycle. Meanwhile, raising the Federal Reserve interest rate has the potential to choke off what job creation and wage gains the economy has started to show.

It is “a cumulative effect,” said Bankrate’s Chief Financial Analyst Greg McBride, “much like running into a stiffer headwind; it will ultimately have an effect on growth. While the goal might be for higher interest rates to moderate growth and keep the economy from overheating, history has often proven that higher rates can ultimately halt the economic expansion.”

Inflation worries many of the people who make decisions about Federal Reserve interest rates. With the Great Recession years in the past, and the unemployment rate increasingly strong, the textbook move is to raise interest rates in order to stay ahead of a weak dollar.

Today in 2018, that textbook might very well be wrong.

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