Unaffordably High Rates To Create Recession

   Considering how fragile the economy is and how moderate income people are hurt when they try to buy things using a loan then soon the damage from rising rates will result in recession. Yes, it is fair for the Fed to try to return to “normal” where real rates are 2% and the QE purchases are sold off in a QT program, but that won’t happen because we are in a brave new world of excessive debt balances. This means people simply can’t afford to pay higher rates.

   The debt / GDP ratio went from about 150% during much of the past century, before 1996, to 365% today, a huge change. If you earned $50,000 in 1990 and had, as a metaphor, a “personal” debt / GDP ratio of 150% that implies you had $75,000 in debt, now if today you still earn the same $50,000 but have a 365% debt / GDP ratio then you have $182,000 debt. Multiply a 4% rate increase times the $75,000 debt in 1990 and you get a payment increase of $3,000; multiply the modern balance of $182,000 times a 2% rate increase and you get a payment increase of $3,650. Thus today’s 2% hike roughly equals a 4% hike in 1990. In 1994 when the Fed raised rates 3% that was a big shock to the economy. Additionally many people earn money in less secure ways than in previous decades, so discounting their income to reflect risk of downward fluctuation in income as a gig economy worker today means their debt service capacity is even worse than it looks. A debt/GDP ratio doesn’t judge one’s personal income graded and discounted by probability of not getting the pro forma amount of income. Yes, I realize GDP is a roughly like a national gross sales figure and is not the same as personal income which can come for retirees from unearned intangible investments. But we have to start somewhere with showing how debt balances are so much bigger today than 28 years ago that the effect of a rate increase could be roughly 2x their effect decades ago. Thus the rate rise for the 2 year Treasury from 20bps to 286bps in the past three years, a rise of 266 bps, could be multiplied by a change factor of 2.43 (the increase in debt/gdp ratio since 1990). Multiplying a factor of 2.43 times a 266 bps rate increase is hypothetically like a 6.47% rate increase. If the Fed raised rates that much in a 3 year hiking cycle that started December, 2015 surely that would cause a recession.
However, much of the debt increase was the federal government which uses low cost, interest-only debt which is much easier to service. Some reduction in private sector debt, since the 2008 GFC, was offset by a growth in federal debt.

2018-10-25T14:19:54+00:00October 25th, 2018|mayflowercapital blog|Comments Off on Unaffordably High Rates To Create Recession

About the Author:

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Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years. Donald Martin’s 19 year career in lending prepared him for fixed income analysis, Securities analysis, and macro-economic analysis used for investing. Donald Martin founded Mayflower Capital in 1993 to provide independent financial advice and implementation of advice about loans. In 2005 Donald Martin changed the company’s mission to providing independent financial advice about investments and financial planning and stopped providing loan services. Donald Martin has a B.A. in Accounting and M.B.A. Finance, and has passed the rigorous CFP® exam and met the experience requirements needed to become a CERTIFIED FINANCIAL PLANNER™ professional. He has been employed in the financial services industries for 30 years and has been investing for his own account for 38 years.