How Higher Interest Rates Would Impact the US Economy

A rise in rates would have a large impact on the housing market and could also take a bite out of asset prices, says Morningstar's Bob Johnson

Robert Johnson, CFA 16 September, 2016 | 1:02PM
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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. As we wait to see if the Fed is going to raise rates in September or at all this year, I'm here with Bob Johnson, our director of economic analysis, to see if the economy is ready for a rate increase and what the impact is going to be.

Bob, thanks for joining me.

Bob Johnson: Great to be here today.

Glaser: Let's talk a little bit about what this could mean for the yield curve. Obviously, the Fed controls very tightly short-term rates. But what do you think the impact on long-term rates is going to be? We've seen so far in 2016 long-term rates actually go down even after the Fed tightened last year.

Johnson: Sure. I don't really think it is, and I think the rest of this year might prove to be a bad time for them to raise rates. I've been lobbying for them to raise rates, and I think they kind of missed their opportunity to do that when it could have done some good on the inflation side. But unfortunately, right now I think the economy is showing signs of weakening, and the last thing they should be doing now is thinking about moving rates and upsetting the apple cart in terms of the economy.

We've seen slower job growth. We've talked about lower hours worked which is not a category that gets a lot of attention, but it clearly appears from that the labor market is slowing a bit. And remember that the consumers are the real driver of this economy, and if employment and hours worked are going down, it's not a good situation for the consumer which is 70% of the economy. So, I'm more worried than I've been in a long time about the economy.

So, I don't believe this year will prove to be a good time to raise rates. Now, some of the data may turn themselves around here, but it doesn't look likely to me. And especially, given the employment data that we've seen recently, I'm particularly worried, but there's other measures, the ISM Purchasing Managers Index has looked a little soft; the Services Index has started to look soft, and again, that's another major portion of the economy. So, it looks to me like the economy is weakening, and I've got to think they are looking at some of the same data that we are and thinking, gee, maybe this won't be the best time.

Glaser: So that means September probably is very unlikely?

Johnson: That's what it seems like to me. But again, they might feel like they have to make a statement, that they are not doing this just because they are seeing the market go down or some random function. So they could move rates just to set a precedent to say, hey, we're in control here. And that's the kind of wild card in there. And certainly, they don't want people to be able to predict too closely exactly what it is they are going to be able to do.

Glaser: Let's say they do raise rates then either this year or early next year, what do you think that does to the rate curve? We know they control the short-term rates. Do you think that the rest of the interest rates are kind of going to move up with that? Are we going to see a bigger impact than maybe we did when they raised in last December?

Johnson: I think that you're going to see an across-the-curve move in rates. I mean, there's a lot of thinking that maybe the longer-term rates and mortgage rates will stay the same even if they just raised the short-term rates. I think the whole curve will move, and I think that's a little bit different than some people are thinking, but we've seen the 10-year had a decent pop last week when the Fed looked like maybe they would raise rates, and I'm thinking that maybe we may surprise folks here that the whole curve may move up, not just the short-term rate.

Glaser: And you think that higher rates would probably have the biggest impact on the housing market.

Johnson: Absolutely. I think the housing market is the one thing that I really worry about with higher rates. So many of the historical categories don't make a lot of difference, but housing has proven to be unbelievably sensitive to what interest rates are. And I'm afraid as rates move up, it's already going to hurt affordability even more.

Glaser: And how about autos sector that's been stumbling a little bit? Is this going to really kind of kick them when they are down?

Johnson: It's going to have some of that type of impact. But again, the rates on auto loans and the terms of them means that 0.25% isn't going to mean a lot there. The bigger impact, as you mentioned, is longer term. It's kind of cyclical. We've gotten back to where we were before the recession in terms of auto sales, and it's going to be very hard to grow sales and certainly a little bit higher interest rate--which will raise leasing and other types of costs--is not going to be helpful. But again, I don't think that's the biggest driving force. I think in some of the demographic issues and the saturation issues is affecting autos. And unfortunately, that's one of the reasons I'm not so positive on the economy.

Glaser: Now, credit card rates can go up very quickly after the Fed moves. Will that really put a hamper on consumer spending power?

Johnson: Yeah, I think that's tied to--the Fed rate may end up being tied to a lot of credit cards' rates directly. But again, with rates often in the 10% to 20% range on credit cards, a 0.25% or 0.5% move doesn't make a big difference. At one time when rates were lower and were used by more people, it was a bigger deal. But now with rates so high on credit cards, it would take a huge move by the Fed to kind of make that a negative impact on the economy.

Glaser: Student loans have been a big question mark over this entire recovery in a lot of ways as the amount has risen very rapidly. Do we know what kind of impact rate increases will have on this big market?

Johnson: Well, you know, it's hard to calculate the exact impact because there are some private loans, there are some public loans out there, some adjust to rates, some only on new loans. So, the direct impact is hard to tell. But with student loans now as big as credit cards and some of those potentially moving up and some significantly over time, that's probably a concern that's kind of a new one that we have to think about.

Glaser: And of course, asset prices, an incredibly important impact of the low rate policy, would you expect to see kind of a weak stock market? We've got asset prices falling elsewhere if rates did rise.

Johnson: Yeah, I think that as higher interest rates offer alternatives to the stock market, it can certainly have an impact on asset prices and asset prices, it's been the primary effect of the Fed. The lower rates have meant that people invested more in stocks. As the stock assets have gone up in price, people have spent some of those asset price increases in everyday consumption. Now this year interestingly some of that consumption, especially at the high end incomes, has begun to slow a little bit potentially because the stock market hasn't done as well this year. So, clearly, if rates further impact the stock market, it's not going to be great news for consumption and that maybe one of the bigger impacts, is what does it do to the stock market and then in fact what does that do the wealthy consumer.

Glaser: Higher rates aren't all bad news though. You think some groups really could benefit from these higher rates?

Johnson: Yeah, I think, unfortunately, it's going to take more than 0.25% to make a difference, but certainly for savers that have been really been getting not such good rates, this may be a little bit better news on that front. But again, the banks may not pass all this along. Getting 0.25% instead of zero isn't exactly a big deal, but it is one positive step.

Glaser: Bob, as always, thanks for your analysis.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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Robert Johnson, CFA  is director of economic analysis with Morningstar.

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