For the first time since before the global financial crisis of 2008–09, the Federal Reserve’s target interest rates are now more than 5 percent. The Fed’s rates flow through to all forms of debt, including mortgages and auto loans. For context, interest rates floated around zero for nearly a decade from 2009 until the economy started to get moving again in 2017.
When the COVID-19 panic struck in 2020, the U.S. government followed the 2008 crisis playbook and took interest rates back down to zero. In both periods, the result was enormous asset bubbles in everything from real estate to stocks to collectibles, whether of art, watches, or more recently, non-fungible tokens. Zero interest rates thus primarily benefited the already wealthy, while those who relied on either wages from their labor or income from savings or fixed income lagged further and further behind.
In early 2022, when inflationary pressures became too obvious to ignore, the Fed began a campaign to aggressively raise interest rates. Many observers argued that rising rates would pop these asset bubbles, but to date, they haven’t.
Rather than acting as an equalizer, rising interest rates are penalizing the indebted working and middle classes, especially those hoping to become first-time homeowners, while again primarily benefiting Wall Street and the already wealthy, for which the rapid rise of interest rates has been a surprising boon.
For example, investment and commercial banks are taking advantage of the widened spread between what they earn on their investments and what they pay depositors and others who fund their activities. This increased profitability may not last forever, but for the moment, banks are benefiting while smaller, less sophisticated “Main Street” savers are suffering losses from deposit yields that pay less than the rate of inflation.
Ten percent of the U.S. population now holds nearly 70 percent of the nation’s wealth. This is up from 60 percent in 1990, reflecting increasing wealth concentration in the era of low rates. It’s no surprise that this top wealth decile also holds most of the personal savings held in banks and in money market funds. With interest rates now above 5 percent, a wealthy individual moving $100,000 into U.S. Treasurys or money market funds will earn more than $5,000 annually while maintaining relatively low-risk holdings.
There has been a large shift in asset allocation as a result, while at the same time, nearly a trillion dollars of funding has left the banks, which are still paying low rates on deposits.
On the other hand, the least wealthy half of the country’s population holds an anemic 2.4 percent of national wealth. What little wealth is held by this half of the population is found in real estate (i.e., homes) and consumer durables (cars and the like). Only a minuscule amount is held in financial assets such as savings accounts and money market mutual funds.
As a result, most Americans are missing out on any opportunity to benefit from higher yields. The one asset this group tends to own is their home, which, all else equal, declines in value as interest rates rise.
Because of inflation, Americans have been depleting whatever savings they had previously cobbled together in order to pay higher prices for groceries, electricity, gas, and other daily needs. According to JPMorgan research, Americans have now used up all of the $2.1 trillion of aggregate excess savings that were accumulated during the COVID-19 period of lockdowns and government handouts.
At the same time, households are borrowing at record levels. According to data from the Federal Reserve Bank of New York, total U.S. household debt increased to more than $17 trillion in the second quarter of 2023, up 20 percent from $14 trillion just three years ago. Households now carry $4.7 trillion of non-housing related debt, also a record level.
Americans hold more than $1 trillion of credit card debt at a time when the average interest rate charged for a new credit card is more than 21 percent. Anyone unable to pay their credit card balance at month’s end is caught in a vicious spiral from which it’s nearly impossible to escape.
During these three years in which household debt rose by $3 trillion, those Americans who collectively owe a total of $1.6 trillion of student loan debt haven’t had to make any repayments on their federal student loans. The three-year suspension of payments ends in October 2023, meaning that households that have already depleted their savings and run up other debts will be faced with difficult choices between severely cutting expenses elsewhere or defaulting on their debt.
With rising rates, debt service is squeezing out other consumption. This will hurt American families, which will be forced to cut back on spending. The economy as a whole will slow as these consumers run out of steam.
Notably, borrowing to purchase a home is becoming prohibitively expensive for millions of Americans. Mortgage rates have climbed to above 7 percent, the highest in more than 20 years, making homeownership increasingly inaccessible. The effect is to block the favored path that American working and middle classes have traditionally used to build wealth for themselves and preserve value for their children.
When a corporation takes out debt to build a new factory, that debt is part of an investment that’s expected to show a profitable return. When the government takes out a bond to build a road or highway, the future productivity of that infrastructure enables economic growth and thus tax revenues to repay it. When an individual borrows for a quality education, that investment is expected to lead to future income to repay it.
However, when interest rates were near zero, and availability of credit ample, governments, corporations, and households could borrow to fund not just capital investments—a good use of debt—but consumption—a bad use of debt. When individuals take on debt to enable consumption, e.g., paying for a vacation, a wedding, or some other consumer good, there’s little prospect of repayment.
When interest rates were near zero, money was free. When money was free, there was no need for any discipline on the part of the borrower, or for discernment between good and bad investment ideas. Households could consume beyond their means. Corporations could send dividends to shareholders rather than invest in future competitiveness. Governments could borrow to fund deficits for any project, handout, or war that they fancied and not have to worry about repayment. Those days are over.
If we continue on this trajectory, we’re likely to see millions of working- and middle-class Americans default on their debt in the months to come. This is a tragedy that could have been avoided.
