How rising interest rates can help the economy and consumers
Posted June 15, 2016
Interest rates could soon begin to climb. And, odd as it may sound, this could ultimately prove a net positive for the typical American consumer.
Following weak employment gains in May, Federal Reserve policymakers are not likely to act on rates when they meet Tuesday and Wednesday. But observers say the central bank could increase rates as soon as July or when they meet in September, a move that would affect interest payments on everything from credit cards to auto loans. But economists say a slowly rising rate environment, as Fed Chairwoman Janet Yellen has promised, would be offset by an economy in expansion mode, steadily creating good jobs with rising wages.
Raymond James chief economist Scott Brown said that when the economy is expanding and consumers are earning more, most Americans can seamlessly absorb small increases in credit expenses while also benefiting from higher interest payments on their savings.
What’s more, with more money in their accounts, Americans can spend more. When consumption ramps up, it creates a virtuous cycle where businesses invest in expansion and add more jobs to keep pace with rising demand for products and services, Brown said. As this happens, demand for workers mounts, too, and employees often can fetch even higher wages.
That type of cycle, Brown said, is ideal because consumer spending accounts for about two-thirds of U.S. economic activity.
“Really, rate increases would amount to votes of confidence in the economy,” Brown said in an interview. “They would be done to return us to a more normal rate environment.”
When it could happen
The latest data from the U.S. Department of Labor show that employers added a paltry 38,000 jobs in May, down from more than 100,000 added the month before and by far the lowest level of the past two years. The May numbers were hurt by a strike at Verizon that shaved off more than 30,000 jobs and ongoing weakness in the energy industry, where low oil and gas prices have cut into earnings and led to layoffs. The anemic number likely will dissuade the Fed from acting at its June meeting.
But if job gains rebound this month, Brown and other observers say the Fed still could move on rates as soon as its July policy meeting.
They point to other data that show continued improvement. The unemployment rate dipped from 5 percent in April to 4.7 percent in May, a level consistent with a healthy economy. Average hourly earnings last month rose 2.5 percent from a year earlier, following a 2.5 percent increase in April. At first blush, the income gains may not impress. But the recent advances are well above the roughly 2 percent level at which wage growth had hovered in recent years, indicating that Americans collectively are beginning to earn more.
Of note, along with the wage advance in April, personal spending rose 1 percent from the previous month, the U.S. Commerce Department reported. That was the largest one-month jump since 2009.
Yellen, in a speech last week in Philadelphia, said economists “should never attach too much significance to any single monthly report.” She said the job market over the last several months has proven “largely positive” and that indications of rising wages are particularly welcome. She stopped short of saying when the Fed is likely to take action on rates, but she made it clear that increases are still on the table for this year.
If employers begin robust hiring anew this summer, positive trends on wages and spending could be the final pieces of data that policymakers need to feel comfortable lifting rates. That is because inflation is likely to move “from lukewarm to warm” when income and spending increase, as BMO private bank chief investment officer Jack Ablin put it in a June report.
The inflation component is important for consumers.
The Fed would raise rates in part to prevent borrowing and spending from rising too fast and causing rapid price increases. If policymakers find the right balancing act, higher wages will more than offset both inflation and rising credit costs.
The U.S. core inflation rate, which excludes volatile items such as food and fuel, was 0.9 percent through the 12 months ended in March, according to federal estimates. The Fed’s target rate is 2 percent, low enough for Americans to keep pace as long as wages are rising but high enough to distance the economy from the threat of deflation. The latter would hurt businesses of all stripes because in a deflationary environment they would be lowering prices on their goods and services and moving backward, forcing job cuts.
In remarks prepared for a late-May speech in Washington, D.C., Fed board Gov. Jerome Powell said he sees “the labor market continuing to heal and inflation returning over time” to policymakers’ 2 percent objective. “The economy is on track to attain the [Fed’s] dual mandate of stable prices and maximum employment,” he said, explaining why he and his colleagues are closely examining rate increases.
“Inflation seems rather benign at the moment, but if we continue to get the wages up, I think we will see it develop; prices will go up,” Mike Matousek, a stock trader at U.S. Global Investors Inc., said in an interview.
Matousek, who tracks investors’ expectations of a Fed rate increase, said markets were braced for a June rate increase but view the odds as stacked against a move that soon. Action is more likely, he said, at the Fed’s July meeting, after policymakers can absorb one more month of employment data.
The Fed in December 2015 increased its key interest rate from a range of 0 percent to 0.25 percent to a range of 0.25 percent to 0.5 percent. It marked the first time the Fed raised rates since prior to the 2008 financial crisis and recession. Following the downturn, Fed officials brought rates down to exceptionally low levels to encourage borrowing and spending in an effort to prop up an ailing economy.
The December increase, on its own, was modest and had little impact on borrowers. But should the Fed embark this summer on a path of multiple quarter-point rate increases over several months, as policymakers have indicated is its preferred route, credit costs would eventually rise more noticeably, observers say.
But when it happens,it is likely to occur gradually, so there is little reason for consumers to panic, Matousek said. “I don’t think people want to race out the door today to get ahead of this,” he said.