Why the Fed has managed to lower the debt service burden
Elevated levels of consumer debt have been one of the reasons why the recovery has been so weak
Consumer debt as a percentage of gross domestic product (or GDP) has been growing inexorably since we began keeping track. From a low of 26% in the early 1950s, debt peaked at 98% of GDP in early 2009. Since then, the consumer has been paying off debt—a process known as “deleveraging.” This has depressed demand as well as consumer spending and has prevented the economy from experiencing the normal post-recession rebound in economic activity. Consumer spending and consumer debt is a driver of Agency REITs like Annaly Capital (NLY) and American Capital Agency (AGNC) as well as mall REITs like Simon Property Group (SPG) and General Growth Properties (GGP)
Interested in AGNC? Don't miss the next report.
Receive e-mail alerts for new research on AGNC
Addressing the consumer debt issue has been one of the major driving forces behind quantitative easing and ultra-low interest rates. Since the Great Recession began, the Fed has engineered a drop in interest rates in the hope of lowering the burden on middle-class households. In many ways, the Fed has succeeded. On one hand, mortgage rates have dropped precipitously. But on the other hand, credit card interest rates have not. Investors who want to take directional bets on interest rates can use the iShares 20 year bond ETF (TLT).
You can see from the chart above that low interest rates have helped reduce debt service payments. This chart shows debt service as a multiple of disposable income. Debt service payments have been falling as consumers have been able to refinance their mortgages and pay off their debt. You can also see the bind the Fed is in—it has to worry that rising interest rates will have a contractionary effect on consumer spending. Consumer spending is anemic in the first place, and the GDP growth isn’t strong enough to sustain much of a downturn in spending.
The Fed has been hoping to create modest inflation. Modest inflation (around 2% to 3%) would allow debt to deflate relative to the economy without triggering large increases in interest rates. The Fed isn’t comfortable with inflation that’s too low. When interest rates are up against the 0 bound (in other words, they’re at 0 and can’t go lower), decreasing inflation means real (inflation-adjusted) interest rates are rising. In a weak economy, that’s the last thing the central bank wants. Japan has been struggling with this state of affairs for two decades—deflation in combination with 0% interest rates means rising real interest rates and very slow growth.