Fed shouldn't raise interest rates too quickly

By Steven Pressman

and Robert H. Scott III

For quite some time, the Federal Reserve has hinted that it will raise interest rates soon. At the end of December, it indicated that rates would likely rise sometime in 2015 - when will depend on economic circumstances.

Raising rates this year is a bad idea because U.S. households are still dealing with the consequences of a quarter-century of income stagnation and debt levels reaching historic highs.

Median household income, adjusted for inflation, has increased by a mere 1.4 percent since 1989. Not 1.4 percent per year. That is the total increase in median household income over 25 years. It works out to $200 more income for 2013 compared with 1989.

At the same time, U.S. families need a lot more to be considered middle class. Unlike 25 years ago, households today need Internet access, cell phones, and computers. A college education is increasingly important to obtain a good job, health benefits, and a retirement savings plan. Families with children need more child-care services because adults are working more and divorce rates have increased.

Households responded to this double squeeze in a predictable way - reducing the fraction of their income devoted to savings, increasing their indebtedness, and hoping for the best in the future.

Greater consumer spending did give the U.S. economy a boost in the 1990s and a good part of the 2000s. But this was growth built on a weak foundation.

The resulting debt levels cannot be sustained over the long term. Debt has to be repaid with interest; with incomes stagnating, interest payments on past debt come to take up a greater fraction of household income, forcing households to cut back on other expenditures.

Once consumer borrowing and spending fell, a Great Recession ensued. Since then, over-indebted households have tried to deleverage, or pay down their debt. Using the Federal Reserve's Survey of Consumer Finances data on U.S. households, we found that debt levels are still far above their 1989 levels.

One problem is that households found it difficult to shed debt during a time of stagnating incomes. A second problem is that high debt levels, relative to stagnating incomes, make it hard for families to pay down debt. This is especially true of families with mortgages that are underwater, or near underwater, which today comprise 40 percent of families with a mortgage.

Two institutional factors also impede deleveraging. First, the Bankruptcy Reform Act of 2005 made it more difficult and more expensive for individuals to eliminate debt through bankruptcy.

Second, many households lack the bargaining power, knowledge, or credit scores to negotiate better terms on their debt. As a result, they are unable to effectively use current income to pay down past debt.

Despite these problems, debt payments relative to income have fallen since 2007. This is mainly due to aggressive monetary policy by the Federal Reserve and government programs like the Home Affordable Modification Program (HAMP), which lowered rates for homeowners struggling to pay their mortgage.

Nonetheless, consumers have been unable to reduce their debt relative to their income. This figure remains unchanged since 2007.

Lower credit-card and car debt have been counterbalanced by greater college debt. And mortgage debt remains a serious problem. It has declined a little bit (relative to household income) since 2007, but after adjusting for inflation it remains at nearly double the level of 1989.

Once the Federal Reserve begins hiking interest rates, households will face greater interest payments on their debt.

Housing is the big concern. Rates for variable-rate mortgages will begin to rise. How much higher rates go for many homeowners will depend on what the central bank does to interest rates. In addition, more than one million HAMP mortgages will reset at higher interest rates over the next several years.

While unemployment has fallen below 6 percent, wages and household incomes have still not grown significantly faster than inflation. Consumer debt remains a problem. Higher rates threaten to reduce consumer spending and derail an economic recovery that is just beginning.

We urge the Federal Reserve to remain diligent and not raise interest rates too soon. An ounce of prevention is worth a pound of cure.

Robert H. Scott III is an associate professor of economics and finance at Monmouth. rscott@monmouth.edu