Fed minutes: How interest income creates a problem for Fed tightening

Personal interest income will rise as the Federal Reserve raises interest rates. Banks will be slow to raise rates on deposits and on CDs. Nevertheless, as the Fed raises rates, this is a problem.

Federal Reserve Minutes released today show confidence in the US economy’s improving growth. They also showed confidence that inflation would drift toward the Fed’s target of 2%. As a result, they reinforce the view that the Federal Reserve will continue to raise interest rates as forecast, in order to tighten monetary conditions. There’s one problem: interest income.

Interest income

I think the interest income channel is an overlooked conduit of Fed monetary policy into the economy. And so, now that the Fed is raising interest rates, it makes sense to talk about what interest income means to the Fed’s ability to tighten monetary policy successfully.

Zero rates starved the US economy of interest income over the past several years. That’s not something the media concentrate on when they discuss monetary policy. But it is important because the private sector is a net receiver of interest. When interest rates go down, the private sector receives less interest income. And that’s a drag on growth. When rates go up, the private sector receives more interest income. And that’s not a drag on growth.

Reaching for yield

I remember when the Fed lowered rates to zero during the financial crisis. My mother was asking what to do about the money in her retiring Certificates of Deposit at the local bank branch. The new CD rates were awful. She was expecting a lot more interest income. So she was considering ‘reaching for yield’. That is, just like everyone else, she considered taking on more risk to get the return she needed.

That’s how risk assets started on their merry way. If the Fed’s base rate yield is zero, you have to look somewhere else for a return. The same is true in Europe, even more so since the major central banks there are taxing reserves. And in some cases, banks now pass this tax through to depositors.

The 30-year fixed rate mortgage is an anomaly

When it comes to interest rates, the US isn’t like the UK where mortgages are variable rate. Most people in the US have fixed rate mortgages. So when interest rates change, fixed rates insulate households in the US.

Now, during the housing bubble, adjustable rate mortgages were en vogue because they allowed people to leverage up. Financial institutions created ARMs to mitigate interest rate risk during the high interest rate environment of the 1980s. But the adjustable rate transfers that risk from banks to households. So when the Fed raised rates beginning in 2004, these mortgages blew up and many households defaulted. These defaults amplified economic distress in the US.

The history of the 30-year fixed rate mortgage

A lot of people don’t know this, but the 30-year fixed rate mortgage standard in the US is an artifact of government intervention. In the early 1900s, typically you had to pay 50% down. And the mortgage amortized over 3 to 5 years, not thirty. That meant that the people who bought property usually had a lot of money already.

To make matters worse, mortgages were like bonds. The debtor paid interest only until the maturity of the loan, when the balloon payment for principal was due. When the Great Depression hit, the principal end-balloon structure proved catastrophic. Capital-strapped lenders couldn’t roll over mortgage loans and property owners defaulted en masse. Debt deflation took hold.

So, Congress created the Federal Housing Administration (FHA) in 1934. The FHA protected lenders by reducing lending risk. But it also helped borrowers. The FHA standardized mortgage lengths at 30-years. And the fixed rate gave borrowers a pre-payment option that allowed households to refinance when interest rates fell. The FHA also reduced downpayment requirements to make house ownership more achievable.

When the US Congress created the Federal National Mortgage Association (Fannie Mae) in 1938, you had a ready set buyer of mortgages to facilitate a liquid secondary market. When the U.S. Congress created the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) in 1970, it increased liquidity in the mortgage market further still.

In short, the US housing market is not a free market. Congress has passed legislation and put structures and controls in place to prevent another Great Depression.

The interest income channel

Other countries have very different set ups. In the UK and Canada, most mortgages have fixed rates for five years or less. That means that households feel the impact of monetary policy very soon after the Bank of England or the Bank of Canadsa make a rate decision.

So in the US, it is corporate borrowers with loan terms tied to variable rates that suffer an interest rate penalty. The rest of the private sector makes out well. That’s because the government is a net payer of interest via its outstanding debt. The private sector is a net receiver of interest income. And that means personal income rises when interest income does.

Look at personal interest payments, part of the personal income and outlays report every month.

Personal income payments and receipts

Source: St. Louis Fed

They plummeted after the financial crisis when the Fed cut rates to zero. That’s a drag on growth.

Only after the economy recovered and began to grow again did personal interest payments begin to grow again.

And remember, the Fed was sucking interest income out of the private sector through its large-scale asset purchases. While rates were at zero, this asset swap replaced an interest bearing government bond with non-interest bearing reserves. It’s a like for like swap of government liabilities, except one pays more interest than the other. That money goes straight to the Treasury. Some of that money would have gone to foreign holders of US government paper. But US households were much bigger losers of interest income.

Federal reserve remittances to the Treasury

Source: Mondovisione

QE and low rates do help corporates who are net payers of interest. That’s the green line in the middle. But the red line – net interest payments – still dwarfs this amount because of interest paid by the government.

Net interest payments, corporations plus household interest income and payments

Source: St. Louis Fed

The Problem for the Fed

As the Fed raises rates, this is a problem if the purpose is to prevent overheating and inflation. Personal interest income will rise as the Federal Reserve raises interest rates. Banks will be slow to raise rates on deposits and on CDs. Nevertheless, on net, increased rates will benefit personal interest income. And that puts more money in people’s pocket. It is a stimulant for consumption, not a depressant.

Meanwhile debtors will slowly become more stressed. Speculative and Ponzi borrowers will eventually get caught out and many will default. The question is when. Judging by current conditions, we have a long way to go until we get there.

Debtors are, therefore, advised to refinance. And pull forward your borrowing, if you intend to take on debt. Given the accelerant from the added interest income, the Fed could be at this for some time to come.

Do NOT follow this link or you will be banned from the site!