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ANALYSIS - Record US debts mean milder Fed rate hikes ahead

BY Alister Bull
Reuters
05.26.04, 4:39 PM ET

WASHINGTON, May 26 (Reuters) - Record levels of U.S. household debt mean the Federal Reserve won't need to step as hard on the interest rate brakes as financial markets currently think to slow spending and keep inflation in check.

U.S. interest rate futures expect a steep tightening cycle to begin next month, adding 300 basis points by the end of next year in a rerun of 1994 when rates went to 6 from 3 percent.

But this time around, the mountain of debt weighing on U.S. households may mean the Fed can keep a "measured" pace in raising interest rates to dampen spending.

Fed Chairman Alan Greenspan recently repeated he thinks the American public can handle its debts. However, that does not mean the high debt-service burden won't help to make monetary policy more effective.

"This time around, consumer finances are much more vulnerable ... the Fed is not going to have to do as much as markets are pricing in," said Dave Rosenberg, chief economist at Merrill Lynch in New York.

The Fed, insiders say, is aware of the big changes in the country's debt profile with many more low-income households joining the credit market, and this may make a difference.

"Debts have soared in the last 10 years and much of that is adjustable rate debt," said Mark Zandi, chief economist at consulting firm Economy.com.

"They won't need to tighten as aggressively to get the desired effect on inflation," he said, adding it may take two years to achieve what markets think will be done in one.

HOW MUCH?

One problem the Fed faces is knowing how much of a change in interest rates is passed on to borrowers.

For instance, a lot of household debt is in the form of home loans and many of these are set at fixed rates for up to 30 years and won't change as rates rise.

On the other hand, recent numbers from the Mortgage Bankers Association show the percentage of adjustable rate mortgages (ARMs) has jumped to 30 percent of new mortgages in the first quarter of 2004 from 19 percent for the whole of last year.

The jump begs the question of why one would opt for a floating rate mortgage with rates heading up, but affordability is a factor as ARMs often offer lower monthly payments.

The association pointed out to the Fed last week that the rise in ARMS may lead to higher delinquencies as rates rise.

There has also been significant debt consolidation as borrowers use cheap mortgage refinancing to pay off more expensive loans. This cuts the debt-service bill but means paying the money off for longer and could make a difference to spending, though exactly how is unclear.

Nor is it clear if all credit card debts rise as the Fed ups the funds rate. Customers who fail to clear their monthly balance may already be paying around 20 percent interest rates on their loans and these penal rates can be capped.

But Stephen Brobeck, executive director at the Consumer Federation of America, says over half America's $700 billion of credit card debt is exposed to higher rates and households earning less than $55,000 a year were a special risk.

"The Fed only looks at (national) aggregates but we are particularly concerned about the lower and middle income brackets...if the Fed raises by 2 or 3 percent, that is going to really hurt," he said.

NOT 1994

The Fed may not have a sure way of measuring this pain in advance. But economists are pretty sure the state of America's household finances is a factor in the assurance that it can be measured in adjusting policy, at least compared with 1994.

The ratio of household debt payments to disposable income has hit a record peak and averaged 13.2 percent last year compared with 11.1 percent in 1994, according to Fed data.

"America is up to its neck in debt," said Howard Dvorkin, president of Consolidated Credit Counseling Services in Florida. "How can this be the richest country in the world when you are hocked to the eyeballs?"

The broader measure of financial obligations is even higher, particularly for families that don't own homes, with 31.8 percent versus 24.9 percent a decade ago.

Economists, who also look at the country's low savings rate, say this means consumers do not have the same amount of pent-up demand and their spending will be easier to cool.

Goldman Sachs expects the Fed funds rate to rise to 2 percent by the end of 2004 from 1 percent. The Fed then pauses until the second half 2005 to end the year at 2-1/2 percent.

"Even a relatively modest tightening will have an impact on consumption," said Bill Dudley, chief U.S. economist at Goldman Sachs. "This is not going to look like 1994 in terms of pace."