Three in four Americans expect interest rates to go up, and they will most likely be proven right once again when the Federal Open Market Committee meets Tuesday and Wednesday. The consensus is interest rates will be increased for the sixth time since June, to 2.5%.
Odds are this will be just fine with most investors, as the UBS/Gallup Index of Investor Optimism survey shows 8 in 10 (who have an opinion on the subject) approve of the Fed's current interest rate policy. And don't expect the president to complain about increasing rates in his State of the Union message Wednesday. He is more likely to focus on how the economy grew 4.4% and created 2.2 million jobs last year -- the best annual performance since 1999.
So why shouldn't the Fed continue to gradually increase interest rates? More importantly, why should the average consumer care as long as interest rates remain so low?
Consumer Spending Intentions
According to a Jan. 3-5 Gallup Poll*, more consumers plan to decrease their spending over the next six months (27%) than plan to increase it (25%). The difference between these two numbers (-2 percentage points) is the same as it was in January 2004, but slightly better than three years ago (-5 percentage points in January 2002). Still, this is only the third time in the last 12 months that consumer spending intentions have been negative on balance.
Job Market Perceptions
One in three Americans say now is a good time to find a quality job, down four percentage points from November and three percentage points from December. This percentage is up two points from the 31% who believed it was a good time to find a job in January 2004.
Why Not Higher Interest Rates?
Even as the U.S. economy grew strongly last year, the Labor Department reported wages and income increased only 2.4%, the smallest increase since the department began keeping records in 1982. At the same time, consumer prices increased 3.3% last year, suggesting the average U.S. employee lost purchasing power during 2004. Still, consumer spending grew 3.8% over the year -- the most since the boom days of 2000.
How can consumers keep increasing their spending even as the overall real purchasing power of the average employee declines? Part of the explanation has to do with the rapid growth of consumer debt, particularly in the form of home equity loans and liens. Another part can be attributed to the disparity in income and spending growth between upper-income households with substantial investment income and lower- and middle-income households that are totally dependent on their wages.
What does all this have to do with interest rates? Right now, the U.S. economy continues to experience structural changes that have created comparatively slow job growth and significant wage compression. Low interest rates and easy credit have moderated the impact of these changes. Higher interest rates will do the reverse.
More significantly, many consumers now have much of their credit tied to short-term interest rates such as the prime rate. This creates lower credit payments and easier borrowing, as long as interest rates stay low. However, higher interest rates will create higher payments for borrowers using adjustable rate loans. Combined with stagnant (or worse) wages, this could create a painful situation for many lower- and middle-income borrowers.
Why Should Consumers Care?
Last week, Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, noted that monetary policy is largely data-dependent. My guess is that the Fed is looking forward to good news on jobs in the new Bureau of Labor Statistics unemployment report this Friday. The warm weather in early January in many parts of the nation and the usual January seasonal adjustments should produce what appears to be a good -- if distorted -- jobs number. Friday's report and other economic averages do not reflect the different economic conditions that upper-income households and lower- and middle-income households are experiencing.
As the Fed considers interest policy, what should they be looking at instead of these averages? I think the Fed should be considering the potential for unexpected consequences among some groups of consumers and borrowers as interest rates increase.
In this same context, consumers should be looking at how much of their debt will experience interest rate and payment increases if the Fed continues to raise its benchmark overnight lending rate. In that scenario, it's easy to see how the heavy debt burden of many consumers today could become much harder to manage in the months ahead.
*Results are based on telephone interviews with 1,005 national adults, aged 18 and older, conducted Jan. 3-5, 2005. For results based on the total sample of national adults, one can say with 95% confidence that the margin of sampling error is ±3 percentage points.
