Interest Rates In A Highly Indebted Economy

The deleveraging constraint

Last week the Federal Reserve reported that U.S. households’ mortgage debt service ratio—the share of disposable income dedicated to mortgage principal and interest payments—fell to a new cycle low of 4.7% in Q2 (Exhibit 1). By our estimates, about 70% of the decline in this ratio since its peak results from lower mortgage rates, including lower rates on new purchases and the impact of refinancing. The remaining 30% results from debt paydowns and defaults. A lower debt service ratio (DSR) is one part of the monetary transmission mechanism at work: by lowering interest rates, Fed policy frees up disposable income for spending on other goods, thereby stimulating economic growth (at least to the extent that borrowers are more likely to spend than lenders).

Exhibit 1: Mortgage debt service ratio at new cycle low

This lowering of the DSR is how monetary policy interacts with the stock of debt when the Fed eases. But what about during the exit process? Many observers have argued that today’s economy has a kind of “deleveraging constraint”—that interest rates are capped at low levels because the overly indebted private sector cannot bear higher borrowing costs. In this world, even 10-year Treasuries yielding 2.3% could be attractive because they still command a premium to cash rates pinned permanently near zero.

There are a few ways in which the deleveraging constraint might work. The first is through the impact of rising rates on the private sector DSR. The diagram below describes the basic relationship between interest rates and the DSR (Exhibit 2). On the x-axis is the average effective interest rate on the outstanding stock of private sector debt—a blend of mortgage rates, floating rate business debt, etc. On the y-axis is the DSR for the nonfinancial private sector as a whole. The upward sloping line means that consumers and firms dedicate more of their income to debt service as interest rates rise.

Exhibit 2: Sustainable DSR achieved with low rates and/or low debt stock

If we assume there is an equilibrium DSR in the economy—above which point higher borrowing costs create unsustainable financial burdens—then the effective interest rate in the economy will be capped at the level r1. However, if the private sector reduces the stock of debt relative to income, then the same DSR could be consistent with a higher interest rate, r2. Thus, the need to keep DSRs low does not imply that interest rates will remain permanently low—only that interest rates will tend to rise in tandem with deleveraging in the private sector.

This is exactly what has happened over the last five years. Exhibits 3 and 4 show the outstanding stock of private nonfinancial sector debt and the corresponding debt service payments, respectively, both expressed as a share of gross domestic product (GDP). Private nonfinancial debt peaked in Q2 2009 at 181% of GDP and has fallen 19 percentage points (pp) to 162% since then. This deleveraging is analogous to the shift in the debt-to-income curve in Exhibit 2—as the stock of debt declines, the level of interest rates consistent with tolerable DSRs moves higher. As shown in Exhibit 4, if short- and long-term interest rates rise along their forward curves, the private sector DSR would remain consistent with historical norms—even with no further deleveraging in the private sector (the BIS presented similar analysis in its latest annual report, although with more downbeat conclusions).

Exhibit 3: Private sector debt loads down from peak

Exhibit 4: Private sector DSR can remain modest if rates rise along forward path

Another way to look at the deleveraging constraint is through the lens of private sector debt dynamics—a framework more often applied to government finances. Changes in debt ratios are a function of three variables: (1) average effective interest rates, (2) nominal income or GDP growth and (3) the savings rate (or in public sector terms, the budget balance; in either case, excluding interest payments). We again show this relationship in Exhibit 5. On the x-axis is the difference between nominal interest rates and nominal GDP growth; on the y-axis, the change in the debt stock as a percent of GDP. The solid line, labeled “s = zero”, represents how much the debt stock would change for different combinations of interest rates and growth, assuming private saving equals zero. The debt stock remains unchanged if interest rates exactly equal nominal GDP growth in this case.

Exhibit 5: Stable debt-to-income ratio with lower rates and/or higher savings

The dotted line, labeled “s > zero”, shows the same thing except with positive private sector savings. In this case, the debt stock could remain stable even with interest rates above nominal growth, because the private sector is running the equivalent of a budget surplus. Lately, our estimate of the private sector savings balance has been approaching zero (Exhibit 6), which means that interest costs need to remain low compared to nominal GDP in order to keep debt levels from rising.

Exhibit 6: Private sector saving no longer strong support for deleveraging 

In a highly indebted economy, there is no fixed cap on the level of interest rates. However, any increase must be consistent with tolerable debt service ratios, the existing stock of debt, and private sector savings (with a number of complications related refinancing behavior, etc.). These constraints have eased in the U.S. in recent years but have not entirely gone away—and in some other countries they remain significant.

It is in light of the interaction between rates and debt loads where Fed officials’ delicate approach to the exit process looks most understandable. Interest rates need to rise in order to prevent an eventual overshoot of the Fed’s employment, inflation and financial stability targets. But private debt stocks might be too high and savings too low to absorb another “tantrum”—hence the abundant caution evident in the minutes of the last FOMC meeting. We are a bit more confident about all of this, but Fed officials remain wary. Investors should expect the soft selling around the exit strategy to continue.