Fed Puts Silver Lining in Consumer Pockets

Hunting for reasons why the economy has remained so robust this year, some Wall Streeters now are pointing at a curious suspect: higher interest rates.

In a twist not altogether unexpected but still surprising in magnitude, rising interest rates have sharply boosted consumers’ earnings from bank CDs and bonds since January--increasing many families’ purchasing power.

At the same time, interest paid by consumers on home mortgages and personal loans has risen at a slower pace, in part because of heated competition among lenders.

So the Federal Reserve Board, while trying to slow business activity with five rate hikes so far this year, may in fact have added fuel to the economic expansion by fattening many consumers’ wallets, experts say.

And because spending by individuals accounts for two-thirds of demand for goods and services, consumers’ sense of wealth is all-important in determining the economy’s trend.

Many Wall Streeters, while admitting that they may originally have underestimated the bullish effects of higher interest rates on the economy, nonetheless argue that the jump in rates will inevitably slow consumer and business spending. “This is not a permanent situation,” says Dan Laufenberg, economist at IDS Financial Services in Minneapolis.

But in the meantime, he says, some Americans are unquestionably reaping substantial gain from rising rates while avoiding the usual pain they cause. Commerce Department data tells the story:

* Surging yields on bank CDs and other interest-paying investments boosted personal interest income to an annualized rate of $670 billion in the third quarter, a healthy rise of $42 billion, or 6.7%, from the fourth quarter of 1993.

* Consumers also earned dividends from stocks and other like investments at an annualized rate of $197 billion in the third quarter, up $12.8 billion, or 7%, from the fourth quarter of 1993 as more U.S. companies boosted cash dividend payments.

* Interest costs paid by consumers, meanwhile, totaled $384 billion (annualized) in the third quarter, just $18 billion, or 4.9% more than in the final quarter of ’93. Those costs include mortgage payments, car loan payments and other such expenses.

With consumer interest income and dividends up $54.8 billion this year while their loan payments have risen a mere $18 billion, “the net impact of higher interest rates . . . has likely been significantly positive” thus far, notes David Kelly, economist at Lehman Bros. in New York.

While conventional thinking is that the biggest beneficiaries of higher savings rates are older people--and that they don’t spend much--Kelly argues that older Americans are in fact more likely to accelerate their spending as their interest income rises, precisely because their lifestyles are dictated by nest-egg earnings.

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Moreover, if the Fed had hoped that higher rates would make people in general feel depressed and less likely to spend, the reverse may have occurred, especially in housing. The government said Thursday that sales of new homes rose in September to a six-month high.

In part, the ongoing strength in home sales reflects consumers’ fears that interest rates will continue to rise in 1995 and price them out of the market, experts say. So current sales, to some degree, “are stealing from the future,” Kelly says. That may make it much more likely that the housing market will stall in 1995, he says.

Others economists point out, however, that home buyers and lenders are finding ways to accommodate each other in order to close deals, even with the jump in mortgage rates this year. For one thing, lower-cost adjustable-rate mortgages now account for 43% of loans made, up from 20% in February, says economist David Lereah at the Mortgage Bankers Assn. in Washington.

“Consumers are easing the blow (of higher rates) by using ARMs,” Lereah says.

ARM loans represent just one of the many changes in the financial system over the past 15 years--changes that, for the most part, have given consumers vast flexibility in their affairs and helped them benefit from rising interest rates rather than be victimized by them.

Consider: Until relatively recently, bank savings rates were controlled by the government, which meant that higher market interest rates didn’t automatically translate into higher income for savers. With savings rate deregulation in the early 1980s and the rise of money market mutual funds, individuals now cash in directly and immediately with any increase in interest rates.

What’s more, deregulation of the financial system has fueled intense competition among deposit takers and lenders. Age-old charges that banks are slow to raise deposit rates but quick to raise loan rates don’t seem to apply this year.

Since Feb. 1, the average yield on two-year bank CDs nationwide has jumped 1.88 percentage points, from 3.56% to 5.44%, according to Bank Rate Monitor newsletter. In the same period, the average four-year new car loan rate has risen just 0.99 point, from 7.91% to 8.90%.

And while mortgage loan rates have risen faster, Lehman’s Kelly points out that the tax deductibility of mortgage interest helps mute the negative effect of higher rates on borrowers.

Still, Kelly agrees with other economists who say the Fed’s steady upward push on rates will eventually begin to hinder consumer borrowing and spending. Most ARM borrowers, for example, have yet to have their mortgage rates readjusted for higher market interest rates, because those changes always occur on a lag basis. “The big adjustments will come in 1995,” Lereah warns.

The danger now is that the lag effect of higher loan rates, and the continuing benefit to the economy of consumers’ sharply improved interest and dividend earnings, could ultimately force the Fed to raise interest rates much higher than financial markets expect to achieve the desired effect of an economic slowdown.

If that’s the case, already reeling stock and bond markets may face much more trouble ahead.

Higher Rates: A Plus?

Rising interest rates this year appear to have benefited--not hurt--many consumers. Interest earnings on savings have jumped by $42 billion (annualized) since the fourth quarter of 1993, while interest payments on consumer and mortgage loans have risen by just $18 billion.

Personal Interest Income

Quarterly, in billions of dollars at an annualized rate:

Third quarter 1994: $670

Personal Interest Expense

Quarterly, in billions of dollars at an annualized rate:

Third quarter 1994: $384

Source: Commerce Department

CD vs. Loan Rates

Banks have sharply boosted certificate of deposit yields this year, while consumer loan rates have risen much less significantly. Changes in key rates since Feb. 1, just before the Federal Reserve Board began to push up rates:

Annualized yield: Instrument Feb. 1 Now 2-year bank CD 3.56% 5.44% 5-year bank CD 4.65 6.15 2-year personal loan 15.22 15.62 4-year new car loan 7.91 8.90

Note: Averages of banks and S&Ls; surveyed

Source: Bank Rate Monitor