The Federal Reserve surprised virtually no one this time around when it announced it was raising its key lending rate by a quarter of a percentage point, nearly 10 years after it started to lower the rate and exactly seven years after it slashed it to zero. Now the big question is this: is the U.S. economy strong enough to withstand the Fed’s rate hike? Its own indicators say so, but key economic indicators point to a possible recession in 2016.
Federal Reserve Puts End to Decade of Decadence
Just in time for the holidays, the Federal Reserve announced it was raising the range of its federal funds rate to between 0.25% and 0.50%. This represents the first increase in nearly a decade and comes seven years after it slashed the rate to zero. (Source: “Federal Reserve Meeting,” Federal Reserve web site, December 16, 2015.)
The move signals the Federal Reserve’s faith that the U.S. economy is healthy enough to stand on its own after the long distant 2007–2009 financial crisis. That said, the Fed said it is in no hurry to rapidly hike rates. It wants to first see how the so-called economic “recovery” can handle the modest rate hike.
But the bank made it clear that it is not in a hurry to hike rates, suggesting “gradual increases” are in order. This is expected to mean the Fed will announce four more modest rate hikes in 2016, ending the year at 1.375%. In 2017, four more modest hikes will follow, bringing the rate to 2.375%.
But again, this will only happen if the U.S. economy responds favorably to the higher rates. The last thing the Fed wants to do is hurt or curb any growth. It’s quite possible that even modest increases will be too much for the average American to bear.
Can America Keep It Up?
The big question is: can the U.S. economy handle the rate hike? Wall Street, which continues to enjoy a long-in-the-tooth bull market, has been expecting it. For those on Main Street, the enthusiasm is a little more muted.
One of the biggest concerns is how the modest rate hike will impact long-term mortgages, consumer loans, and other forms of interest-sensitive credit. Despite the jobs data, the overall U.S. economy appears to be on less-than-solid footing.
The best way to see how the U.S. economy is doing is to see how consumers are faring. After all, consumer spending accounts for more than 70% of the country’s gross domestic product (GDP). In a nutshell, retailers are getting hammered.
The SPDR S&P Retail ETF (NYSEArca:XRT), an exchange-traded fund that tracks the performance of well-known retailers in the U.S., is down roughly 13% since the summer. Specifically, brands such as Sears Holdings Corp. (NYSE:SHLD), Macy’s Inc. (NYSE:M), Nordstrom, Inc. (NYSE: JWN), and Gap, Inc. (NYSE:GPS) are getting crushed.
Americans just don’t have the money they once did for nondiscretionary spending. That doesn’t bode well for a country that expects the disappearing middle class to be the engine of its economic growth.
Rising interest rates will also hurt those looking to pay down debt. I know everyone says American households have learned from the heady days before the financial crisis and are in the best shape in years…but I’m not so sure.
U.S. Household Debt Soars
It’s not a total surprise to see that U.S. household debt levels are at their highest since 2010, driven largely by increases in mortgage lending, car loans, student loans, and credit cards. (Source: “U.S. Household Debt Creeps Back Toward Peak,” Financial Times, November 19, 2015.)
In the third quarter, household debt climbed by $212 billion to $12.1 trillion. Mortgage debt was up by $144 billion, the second-largest increase since 2007. Auto loans were up for the 18th consecutive quarter, while auto loan debt inched up $39.0 billion to $1.05 trillion, the biggest increase since 2005.
Meanwhile, student loan debt hit a new record of $1.2 trillion in the third quarter. To add salt to the unemployment wound, the delinquency rate on student loan debt rose for the second consecutive quarter to 11.6%.
Rising rates, no matter how modest, will be tough medicine for Americans in debt—and that’s most of us. This could be a crimp in the country’s growth trajectory.
For those with money, that’s another matter entirely. If I’m going to be an objective contrarian investor, I have to wonder that if the stock market can do this well after years of reporting mediocre earnings on the back of a worsening global economy, how well will the stock market do when the economy is actually doing well?