Latest / Market Pulse / Decoding Interest Rates and their Economic Impact
Transcript
- Maria Urtubey (00:01): Welcome to the Market Pulse Podcast. I'm your host Maria Urtubey member of the Risk Advisors Team. This group identifies economic considerations and leverages data and analytics to translate into industry insights and recommendations supporting our clients during economic uncertainty, while uncovering growth opportunities in consumer risks. I'm pleased to welcome back our panel of experts in the Risk Advisors Group, Dave Sojka, Jesse Hardin, Tom O'Neill, and our practice leader Thomas Aliff. Welcome gentlemen. Speaker 2 (00:41): Hi, Maria. Maria, good to afternoon. Maria Urtubey (00:45): The economy has made considerable progress, but inflation is still too high. Gerome Powell at the press conference on April 3rd, although not yet at the 2% goal, inflation has cooled off, allowing the Federal Reserve to shift its attention from racing rates to when to lower rates. Today we will be focusing on interest rates, a topic that has been escalating, the pain points list based on the feedback shared by our market pulse audience. For some of you, all of these economic terms are terms you hear and look into every day. For the rest of us, the Federal Reserve referred to as the Fed sets the federal fund rate, which is the interest rate at which banks in the US lend money to each other. So it influences other interest rates in the economy, including rates on personal loans, mortgages, and saving accounts. And the reason the Fed adjust it adjusts interest rates is to achieve its mandate to promote maximum employment and stable prices for the American people. Maria Urtubey (01:56): How do the Fed interest rates affect the economy? It's a monetary policy tool By raising or lowering interest rates, the Fed influences borrowing and spending in the economy. For example, the Fed raised rates for from almost zero to years ago to combat in rising inflation after hitting a 40 year record high. The last time it did so was last July. Raising interest rates, cool off spending, and the costs associated with the goods and services as a result. Conversely, when the economy is weak or inflation is low, the Fed may lower interest rates to stimulate borrowing and spending. So interest rates also affect borrowing costs investment and saving currency value. And of course, the housing market. We are currently experiencing the effect of home affordability from higher interest rates. Yet the central bank's benchmark has remained unchanged with federal rates in the range between five and a quarter and five and a half Since last year, Powell continued to describe the US economy overall as, and I quote again, one of solid growth as strong, but rebalancing labor market and inflation moving down, end of quote. But he also painted the scenery as bump a bumpy path. And we have heard that unwavering numbers would weaken the case for rate cuts this year. A chance of a recession would support interest rate cuts as of landing would not, the roadmap is not just bumpy. There are mixed signals along the way. I'm hoping my colleagues can shed some light on this today. Jesse, given all of this, what metrics should we be watching out for? Jesse Hardin (03:50): Thanks, Maria. Yeah, I was, I was going to joke, maybe we should just look at metrics from baseball. 'cause It seems there is up and down as the metrics that we watch from for interest rates. I would say it's probably good to, , to mirror what the Fed's looking at or even what the, what the interest rates or sorry, what the market's looking at. So looking at things like inflation, labor spending, whether it's retail, good services, homes, autos, et cetera. All of those really, I think, have a role to play in the Fed's analysis, really with the state of the economy. The Fed's preferred inflation gauge is going to be the PCE Deflator. I know that sounds, sounds technical. It's just really it's similar to CPI. What it does is it just looks at a basket of goods and services. Jesse Hardin (04:39): The big difference between PCE, which is the personal Consumption Expenditures index and CPI, which is the consumer price index, is really just the weights that they put on the goods and services. So I think the big difference that we've seen lately is that there's more of a focus on shelter. Certainly shelter being the cost that it takes to live where you live, where you rent where you own your own home. Those metrics have been elevated now, and it's, and it's leading to inflation that's making the fed's job pretty hard to do. So I think watching the PCE watching things like the CPI also for labor, looking at the Bureau of Labor Statistics monthly report, that's going to give a good indication of the movement in the labor force from month to month. Jesse Hardin (05:34): And the economists are going to really watch that movement month to month to see how is our job market growing? What's the strength in the job market? They're going to look at things like the unemployment rate. How is that moving? We typically trend to a 4% unemployment rate for a healthy economy. So are we, , are we close to that? Are we higher? Are we lower? And then I would say, , it's interesting how much visibility I think these, these metrics are getting right now. And really a caveat would be that we've talked about it before, it's always good to keep in mind the motivations that underlie the discussion and the public discord. So, right now the Fed is obviously looking at these metrics maybe a little bit differently than somebody in the stock market would the Fed's really wanting to make sure that they see data that, that indicates that inflation is in check where the stock market's probably wanting to see a different set of metrics so that they can accurately judge when the rate cuts are going to happen. Jesse Hardin (06:35): And rate cuts are obviously more beneficial to the stock market. And so I think a good example would be there's a story the other day about an American CEO calling for an 8% Fed funds rate. And that's obviously a significant jump from where we are today. If you read the article further, it really talks about the CEO talking about a range of rates to be prepared for and really that's what they were doing within their company. So again, I can't stress enough. You've got to know the underlying details of who you're listening to and kind of what they're focusing on to, to really get a good picture, I think, of where interest rates and where inflation and some of these other metrics are really going. Maria Urtubey (07:17): Thank you, Jesse. Following this general economic scenario, it's timely to turn over to more of the specifics. And this question is for you, Tom, what impact do changing interest rates have on banking? Tom O'Neill (07:31): Well, there's, thanks for that, Maria. There's actually a pretty simple way of answering that question. Unfortunately, reality is always a little more nuanced than simple. So I'll start with the simple part. Increasing interest rates raise a bank's profit margin. So banks make money by lending out money to borrowers, and they charge an interest rate on that, obviously. And when interest rates go up, they're able to raise the interest rates on that, that money that they lend out. And in exchange they get more for those higher interest rates. And it is true that they also tend to raise interest rates on deposits and the other assets that they have that fund those loans. But raising on, raising the interest rates on those tend to lag a bit behind and aren't as fast as what is typically done when they raise interest rates on the lending activity. Tom O'Neill (08:29): So, the short answer is rising interest rates increase profit margins, which is a good thing for banks. The more nuanced reality though, is that it's more complicated than that. Usually rising interest rates, as you explained in in your introduction there is a deliberate act to try and cool off the economy. It's exactly what we're seeing right now with, with the Fed trying to fight off inflation raising interest rates for the specific purpose of decreasing economic activities to try and rein in inflation. And as such there is correspondingly less commercial and consumer borrowing being done. So even if the profit margins on those, those loans are, are increasing the amount of activity may be decreasing during the same time period. And then when you also factor in, that's that typically associated with a cooling economy, you see other things like a rise in delinquency rates and a rise in charge offs. Tom O'Neill (09:31): It means that, , fewer of those, those loans are being paid. And, and so there's more risk in expense associated with those. And there's also opportunity costs with rising interest rates. If I lent out money yesterday at a lower interest rate and now there's higher interest rates today that's an opportunity that I've lost out on being able to take out that, that that increased rates and my current assets are lower valued. So there's a lot of different things that are mixed into this. To be able to say, well, rising interest rates are good and lowering interest rates are bad for banks. It's usually a mixed bag. Maria Urtubey (10:14): And if rates were to be cut this year, what do you think the impact would be? Tom O'Neill (10:21): I'd love to say that we're going to see multiple rate cuts and banks will be happy and there will be dancing in the streets and everyone filled with joy. But, but it all depends on so many different factors. I mean, what are the conditions when the fed cuts rates? , when will the Fed cut rates, , how much will they cut it by? How many times will they cut it? All of these things have an impact on not just the banking, , approach, but the conditions that the, the banking industry is operating in. So again, would love to say that there's going to be dancing in the streets, but we'll have to wait until further into the year to see if that actually happens. Maria Urtubey (11:09): And Dave, given what we've heard from Tom, what is the sentiment in the mortgage environment? Dave Sojka (11:15): Well, I was going to ask Tom, is it Martha and the Vandellas or Bowie and Jagger for dancing in the streets? Oh, I, Tom O'Neill (11:21): I'm definitely going, Martha. Yeah. Dave Sojka (11:23): All poor dancing by the two guys, right? So I'm going to put away my dancing shoes, unfortunately, given the announcements from the other day on where inflation is at. The current situation right now is our, one of our most famous former presidential candidates, James McMillan II, had said, rent is too high. Current rate says of April 1st of this year, 30 year rate's at 7.46, the 15 years at 6.68, and the 30 year jumbles at 7.49. The rise in inflation has brought mortgage rates to their highest rates levels in the over 20 years. Again, that mortgage rate for 30 year fixes more than doubled what most paying during 20 and 2021. And while mortgage rates aren't directly linked to the federal fund rate, they are influenced by how investors think the fed moves will impact the broader economy. Dave Sojka (12:23): So as the rates go up, mortgage rates go up, as rates go down, mortgage rates will eventually come down. Our recent credit trends data has shown that the impact of this has been mortgage origination volumes have been decreasing, , over the course of 2023, but really they've been in line with what we've seen from 2018 to twenty one, a hundred forty 7 billion in originations, and then in 1.2 million units as of December 2023. How are Americans reacting to the higher rates? Well, well some are actually starting to put down for discount points, which are a one-time fee paid at closing to the lender. They're in exchange for a lower interest rates , paying that one discount point, is that the equivalent of paying a fee of 1% of the loan amount. And really this is a hedge for borrowers in terms of they're not sure how they're going to be able to afford the mortgage in the future. Dave Sojka (13:20): So really it's a hedge against risk. But it's that always that common in low rate environments. One of the main drivers too has been, again, a supply issue. So we've talked about high interest rates and inflation, but also supply, and that's really driving up the prices, making affordability an ongoing issue. So the other thing that Americans can do instead of purchasing home is rent. And when we compare mortgage to rent, the average monthly mortgage payments $174 higher than the average rent in the US according to a study by Home Bay if we look at, and again, it varies by, by region, by city. And if we look at a city's price to rent ratio, which again, looks at the price of, of rent relative to the price of mortgage anything like really below 15 means it's pretty good if it's if it's above 18, that's, it's pretty high. And so 45 out of the 50 most populous urban metro areas have a rent ratio of over 15, meaning it's actually better to rent than to buy housing in America is only getting more expensive. But home prices have increased more quickly than rent prices. Maria Urtubey (14:33): Yeah. And in, in that case, can we say the dancing in the streets is a common theme in mortgage, as it is in banking? What are you expecting if rates were to be cut? Dave Sojka (14:43): Yeah. well, I guess fortunately US home prices declined in January for the third consecutive month due to higher borrowing costs, according to s and p CoreLogic, K Schiller Ho Home Price Index. But prices year over year jump 6% the fastest annual rate since 2022, really for housing to recover. A couple things have to happen. First obviously we need to see the inventory of Homes for Sale turn considerably high. There's a, a, a definite shortage in really that's in really new housing new houses being built. Obviously, mortgage rates would have to cool off. Experts think it might be imminent, but I think the recent inflation news has definitely pushed that back to the latter half of this year, mortgage rates really returning more normal upper four to 5% would help the housing market and that count and go back to the levels that we saw back in 2014 to 2019. But it's really an additional balancing act for the Fed. Cutting rates too quickly lowers mortgage interest rates, drives demand, higher demand drives up prices. So it's a real tough balancing act for the Fed. Maria Urtubey (15:49): Yeah. Thank you Dave. Thomas, you shared with the risk advisors team a very different take on interest rates. Would you mind sharing your perspective for the auto vertical with our market pause audience? Tom Aliff (16:02): Yeah, definitely. And to quote another song on the terms of interest rates Leanne Womack I hope you dance, so we'll see where we go with all these things. But as it relates to some of the most important things in the auto market the payment to income after the credit score has been one of the key drivers in terms of understanding downstream payment risks. So when we think about what that means is you have a monthly payment for a vehicle, and then you have the income for the person. We know things where things have gone, how they've occurred, and the inflation that has occurred within the automotive space for both new and used vehicles was really quite high, outpacing regular inflation by some dramatic margin. Tom Aliff (16:51): So the impacts to the overall monthly payment was more impactful in the auto space with a payment to income ratio being higher as incomes, were not keeping pace with the inflation associated with that space in particular. So as we're looking at it if we end up seeing some form of decline in the total price of vehicles we may see that people are better off in terms of being able to either refinance or do something with that. And on the interest rate side, a hundred basis point drop that's going to be a fraction of a monthly payment compared to the overall payment. But what it does though is it does create a sentiment and over the life of the loan, from an amortization standpoint, it does create a massive opportunity for refinance as well as new origination. So as we explore some of those things, I think the places to definitely watch and to understand are where is the loan to value sitting? Where's the payment to income sitting? And how does it fit within the current credit structure that someone might have. And, that's going to be regardless of where, where rates end up going. Maria Urtubey (18:01): Thank you, Thomas. Jesse, your general economic insight, got the discussion started, how should we interpret the Fed's latest communication in closing? Jesse Hardin (18:13): Yeah, Marie, I'll take that. But first I want to highlight that was pretty cool to hear Thomas quoting a country western singer. Mm-Hmm. . So pretty, pretty awesome there. , what I would say is when we think about the, the velocity of all the comments coming out of the fed about what's happening in the economy and in the markets. It's good to, I think, probably look at some of the latest remarks. I think as you had said, Maria, the April 3rd remarks from Jerome Powell with probably some of the remarks that get, I guess looked at the most. So Jerome Powell was at Stanford Graduate School of Business, I guess Go Cardinals. But in those remarks, he reinforced a couple points that we can hit on and I want to quote them just so there's really nothing lost in translation. Jesse Hardin (19:00): So the first thing he said is, quote, labor market rebalancing is evident in data on quits job openings, surveys of employers and workers, and the continued gradual decline in wage growth. And I think what he's saying there is just the that the labor market is coming to a, a more of a normalization where, , a typical growth number like a, a three month moving average could be 250,000 jobs or so. And, and so we're seeing that normalization in the labor market. And, and that's a good thing. There's as we looked at where the economy was going when it was so hot labor and spending were kind of the, the keys that really caused more of this concern. And so that normalization, again, in the labor market is something we definitely want to see. Jesse Hardin (19:50): He also said, we do not expect that we will that it'll be appropriate to lower our policy rate until we have greater confidence that inflation is moving sustainably towards 2%, given the strength of the economy and the progress on inflation so far, we have time to let incoming data guide our decisions on policy. Again, I think reiterating that the data's going to kind of dictate when the move needs to happen. So I, I think some in the market have in the stock market may have said the goalpost seems to be moved a little bit. We were trying to get closer to 2%, and now you're saying we need to hit 2%. And so I think really what we're hearing is just that the data needs to indicate that that inflation is really in check. And as we see these hot inflation reports coming out, I think that's what's calling into question. How inflation is really moving. Jesse Hardin (20:40): He did reiterate that if the economy evolves broadly as, as is, as is expected, especially with the FOMC participants , indicating, so the, the different governor, the, the Fed governors that that, that offer their opinion as well, it seems likely to be appropriate to begin lowering policy rates at some point this year. And so I think that's going to continue to, , kind of show that that, that the, the, the move is towards rate cuts. It's just a question of does the data show that it's time to do that. Prior to the, the report that we saw, the CPI report out April 10th, the CME Fed Watch tool, which is like a prediction of likelihood of rate cuts, was showing a 63.5% probability of at least a 25-basis point cut in June. Looks like that's probably off the table now because of the heat that we've seen over the last three or so CPI reports. Jesse Hardin (21:37): I think, again, continue to watch the velocity at those reports as they come in. And then a couple other things. So, these inflation reports have come in with an emphasis on how some of the service costs are really sticky. And so I think that's going to really cause the Fed to really look at that data closely and really determine how does how does that data indicate a move needs to happen in the rate cuts. And then lastly, I think just not forgetting that the presidential election is coming through. And so in terms of timing that's always a play as well as the Fed's going to really try to refrain from any large movements or any movements for that matter around that election time. Maria Urtubey (22:23): Thank you, Jesse. It seems we have a bumpy path ahead. We're not there yet, but we are hopeful that we'll be dancing when we do. Jesse Hardin (22:31): Yeah. We're, we're practicing right now. We're practicing in our homes. Yes. . Maria Urtubey (22:36): Yes. Thank you. Thank you, Tom, Dave, Jesse, Thomas for your participation. To our listeners, thank you for joining us. If you have questions or suggestions for future podcasts please reach out to us at risk advisors@equifax.com. We look forward to hearing from you. And until next time.