A review of household debt may shed some light on why monetary policy had so much economic traction from 1950’s until 2000. In the early 1950’s household debt as a percent of GDP was less than 25% of GDP. By the mid 1960’s it had risen to the low 40%’s range which lasted until the early 1980’s. It then began a gradual climb and by 2000 household debt was 66% of GDP, before soaring to 98% of GDP in 2007. One of the primary drivers of the surge in household debt was the decline in interest rates after 1981. Most consumers determine what they can afford to buy based on the monthly payment. As the cost of money fell they were able to carry more debt, which is why household debt soared from 44% of GDP in 1982 to 98% in 2007. The accumulation of debt was also made possible by the huge run up in home values and a significant decline in lending standards between 2000 and 2007. Since 2008 home prices have dropped by 30% and banks have raised lending standards, which has effectively neutralized much of the benefit the economy received whenever the Fed has lowered interest rates. Household debt has fallen from 98% of GDP to 81%, but more than half of the improvement was the result of consumers defaulting on mortgages, auto loans, and credit card debt. As noted previously, income growth has been less than the cost of living in recent years and the personal savings rate is less than one-third of what it averaged between 1958 and 1987. We think the household debt to GDP ratio will need to drop to 65% of GDP, and the savings rate will need to climb above 7% before a lasting self sustaining recovery can take hold. This is likely to require at least several more years since income growth is so feeble.
The pattern seen in household debt is also very apparent in Total Credit Market Debt (TCMD) as a percent of GDP. Between 1946 and 1980 it remained remarkably stable, and in 1982 TCMD was $1.65 for every $1.00 of GDP. By 2007, it had risen to $3.70 of debt for each $1.00 of GDP. This is clearly the elephant in the room. The Federal Reserve has been fighting deflation since the financial crisis, since a pronounced and prolonged decline in GDP would make it increasingly difficult for borrowers to service their debt. It is also why the budget deficits were necessary to keep aggregate demand from plunging and tipping us into a deflationary spiral. The risk of deflation has lessened, but it is still the greatest risk our economy faces. This is why too much austerity in the short run could become problematic and why the Fed has taken out an insurance policy by expanding QE3.
In the movie Apollo 13, the astronauts had one chance and a small window if they were to successfully return to earth. If they came in too shallow their capsule would bounce off the atmosphere. The Federal Reserve has one chance to get the unwinding of QE3 right and begin the process of normalizing monetary policy. We believe the Fed will wait until they see the full impact of the tax increases and sequester, which are projected to cut 1.75% from GDP growth over the next year. Health care represents 15% of GDP, so the implementation of the Affordable Care Act in 2014 has the potential to be disruptive not just for the labor market but for the economy as a whole. More than anything, the Fed will want solid proof the economy has achieved a self sustaining growth path before they begin to scale back QE3, so they will err on the side of caution. We think QE3 will be maintained through the end of 2013.
