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Minyan Mailbag: Sensitivity to Rates



Editor's Note: Minyanville is a community of people who share an interest in fiscal literacy. As perspective is an important aspect of our daily routine, we share this email with hopes that it adds balance to your process.

Prof. Succo,

In relation to your pondering about absolute vs. relative changes in rates...

I had an exchange (which I'm still tracking down) with a commentator over at RealMoney. He was making the point that the high amount of debt (esp. personal and real estate) in the US was not a concern, and showed a chart of how the ability to service the debt (i.e. payments relative to income) has remained almost constant for 25+ years, entirely & proportionally due to currently-low interest rates.

I returned a question asking him if he would examine the sensitivity of this ability to changes in interest rates, since he had the data. I'm driven to this by the simple realization:

  • at a 12% interest rate, a rate change of 1/2 a point represents a 4% change in "ability to service debt"
  • at a 3% interest rate, a rate change of 1/2 a point represents a 16% change in "ability to service debt"

It is this (what I view as extreme) sensitivity to changes in interest rates that makes our current debt levels frightening. We are generally not using this low rate environment to shift to savings and investment.

Minyan Tracy


Of course, it is impossible to tell the actual sensitivity given the many non-quantifiable variables such as consumer elasticity for demand. We just don't know how consumers will react from their current level of high indebtedness. For example, would they actually increase spending given a small change thinking they better buy now, or would they curtail spending very quickly? My guess is the latter, but there is a small probability of the former.

And we also have to ask ourselves would the Fed actually let rates rise even if foreign lending curtailed dramatically, driving the dollar down and rates up? The Fed doesn't really control long term interest rates, but I know and you know that isn't really true if they decide to act unconventionally by monetizing (printing currency and buying our own debt). I am already suspicious that they do this on the margin now; a full scale monetization would be interesting indeed.

My thought is that our economy is extremely over-dependent on zero real interest rates (I don't believe in the government inflation numbers, so I still think real rates are essentially zero) and speculation in asset prices. I believe we are at a point that is the antithesis to the early 1980's in terms of the value of financial assets.

I had thought that this period would end with a dramatic decline in the dollar and rising interest rates. Scott has pointed out that it doesn't have to be that way, at least initially, before trouble begins with financial asset prices.

The markets now are purely liquidity driven to a degree which I have never seen. Wall-Street and Pennsylvania Avenue have tried to convince the markets that the economy is business as usual. Well, the pension holders at United Airlines know how Wall-Street works and I think we should all learn from that lesson (and many more) and soon.

Minyanville is here to point out those lessons. We cannot predict the future, only layout alternative probabilities to those of self-interest. My main lesson: economic activity over-dependent on zero real interest rates and ever increasing debt at all levels is not stable.

Prof. Succo

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