(Bloomberg Opinion) -- A strange disconnect has emerged in financial markets. Investors now expect the Federal Reserve to raise interest rates this year much more aggressively than previously thought, to combat persistent inflation. Yet their expectations for how high rates will go haven't changed much, reaching around 2% in late 2023 — the lowest cycle peak since the mid-1950s. Beyond that, they actually foresee a decline, suggesting that a sharp economic slowdown will force the Fed to reverse course.
I think such forecasts are misguided, and stem from a misunderstanding about how the Fed's monetary tightening will affect the U.S. economy.
How could a federal funds rate of about 2% — which most economists see as below “neutral” — possibly prove constrictive? The most plausible explanation centers on the burden of non-financial debt, which climbed sharply during the pandemic and now stands at about 2.7 times gross domestic product – the highest level in U.S. history outside a brief spike related to the collapse in GDP at the onset of the pandemic. As the Fed pushes up interest rates, the cost of servicing all that debt will rise and could conceivably choke off growth.
Yet this story is woefully incomplete. First, it ignores who the debtors are. The federal government was biggest borrower during the pandemic, boosting its debt-to-GDP ratio by nearly 20 percentage points, in large part to pay for emergency aid packages. By contrast, debt ratios for households, non-financial businesses and state and local governments barely budged. This matters because a rise in debt service costs won't necessarily force the government to cut back. On the contrary, the path of least resistance for politicians is larger budget deficits, not spending cuts or tax increases.
Second, household and business finances aren't as bad as debt alone might suggest. Household balance sheets are actually relatively healthy. The value of stocks and real estate has soared, such that total household net worth stood at almost 8 times disposable personal income in September 2021, up from about 5.5 times at the start of the last economic expansion in 2009. Over the same period, debt service costs as a share of disposable personal income have plummeted, to 9% from 12%. The improvement in household finances is reflected in household credit scores: The average FICO score reached 716 in April 2021, up from 686 in April 2009.
Third, one must consider the structure of liabilities. U.S. household debts are largely in the form of long-term, fixed-rate mortgages, which shield them from increases in short-term interest rates. This stands in stark contrast to countries such as the U.K., where short-term rate increases swiftly push up mortgage payments for both new and existing borrowers.
Fourth, higher inflation is the debtor's friend. Unexpected increases in prices and wages reduce real interest rates and shrink debt burdens in relation to income.
So if raising rates to 2% or so won't unduly slow the economy, what will the Fed do? Simple: It will have to take rates much higher, as it has consistently done during economic expansions. Since the central bank got inflation under control in the mid-1980s, tightening cycles have typically ranged from 3 to 5 percentage points, making the 2-point increase of the last expansion the clear outlier. And if inflation proves more tenacious, then the episodes of the late 1970s and early 1980s — which included increases of 10 percentage points and more — could eventually become more relevant benchmarks.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is senior adviser to the Griswold Center for Economic Policy Studies at Princeton University. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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