Variable Rates May Fuel Recession

The widespread use of variable-rate mortgages makes U.S. consumers more susceptible than ever to rising interest rates and could mean that current Federal Reserve credit tightening will lead to an early recession. Before the advent of variable-rate debt, only the last few people to apply for loans during a time of tightening credit costs agonized much over higher rates. Now, with a third of U.S. consumers holding adjustable-rate mortgages and other consumer debt also subject to floating rates, many households will be sweating out higher interest payments.

About 70% of all U.S. households have interest-bearing debt, but the percentage varies significantly with income level. About 40% of households earning less than $10,000 have debt. That percentage rises significantly with income, reaching a peak at 86% for households with incomes of $40,000 to $50,000. About 62% of the debtor households have a mortgage and/or a home equity loan, 86% have some form of consumer credit--which, in addition to installment debt, includes the outstanding balances on non-installment loans, revolvingcredit and credit cards--and 47% have both types of debt.

Because there is no data on interest-bearing assets of debtor households, I assumed in my research that debtor households had the same assets as non-debtor households in the same income category. This probably results in an overstatement of assets, particularly for low-income groups. Despite this, except for those with incomes over $50,000, most U.S. households have substantially more debt than assets.

The best gauge of how consumers are affected by rising interest rates is discretionary income, defined as consumer outlays for durable goods plus savings. This represents that part of the household budget that consumers normally adjust as their economic circumstances change.

I have looked at the impact of higher interest payments on consumer spending in terms of how much households in each income group would have to cut their outlays on consumer durables to compensate for a one percentage point rise in market rates. Overall, the impact of a one-point rise in rates is modest, ranging from a decline of 3.6% in durables spending for households with incomes under $10,000, to 1.4% for households in the $40,000-to-$50,000 bracket. For households with income over $50,000, durable spending would presumably rise--by 1.6%--because the additional interest gained from their investments more than compensates for their higher interest payments.

However, there are limits on consumers’ willingness or ability to offset higher interest payments by modifying spending or savings out of current income. Consumers faced with a sizable increase in net interest payments may very well liquidate debt by deferring further credit purchases and paying off old debt.

Because consumer installment credit turns over rapidly, widespread decisions not to assume new debt will result in a significant decline in debt outstanding. The current U.S. economic recovery, characterized by sluggish personal income growth and income polarization favoring upper-income groups, has depended heavily on unprecedented expansion in the use of credit as well as record-shattering reductions in savings rates.

Over the course of the expansion, real personal consumption expenditures have risen at a 4% annual rate, virtually matching the 4.1% GNP growth rate. If not for the sharp growth in consumer installment credit, real consumer spending would have risen only 2.4% annually.

In my study, I assumed that households faced with increases in net annual interest payments equivalent to 20% of their durables spending--or discretionary income, if that is larger--would decide to pay off debt to offset the effects of rising variable-rate payments. The average household allocates 20% of its total durable-goods spending to purchases of small durable items such as electric can openers and coffee makers. Beyond that, higher interest payments would force people to forgo spending on big-ticket items such as major appliances or cars.

Moreover, because debt leverages money both when a loan is taken out and when it is repaid, the potential impact of debt reduction is multiplied. The typical $40,000-to-$50,000 income debtor household, for example, would have to cut its debt by $610 to avoid the $74 increase in annual payments stemming from a one percentage point rise in short-term rates.

Such a one-point increase in interest rates might not cause households to pay off existing debt or forgo new debt. But if market rates increase substantially more, debt liquidation is much more likely.

If market interest rates rise by 4 or 5 percentage points, for example, I would expect spending declines equal to 20%-30% of consumer durables spending. These are very substantial reductions, and since market rates already have risen three percentage points since the first quarter of 1988, one might expect that households already would have made some cutbacks. However, experience suggests that there is a considerable lag in consumer reaction to rising interest rates, reflecting the average householder’s reluctance to give up the good life.

Households with especially heavy debt exposure--those with both consumer installment and mortgage debt, all of which have variable rates or are refinanced within a year’s time--would be much harder hit by rising interest rates. Although these heavy debt users represent only 13% of all American households, they are saddled with 40% more debt than the average debtor household. Because variable-rate provisions cover all of their debt, that debt is much more sensitive to market rate changes. As a result, the amount of debt liquidation necessary to keep total interest payments at the level they were before rates began to rise would be substantial.

Even a 20% drop in durable goods spending would mean a fall in U.S. gross national product of about 2%, not counting the related recessionary decline in consumer goods inventory investment, or the falloff in capital spending or housing activity. Since in the average postwar recession in the United States, GNP has declined 2.2%, the Federal Reserve may very shortly be pushing interest rates to a point at which a deep recession is a real threat.