Interest Rates and Inflation Targeting: How the Fed’s Monetary Policy Can Drive Growth in ARM

From June 4-5, the Federal Reserve (Fed) sponsored a research conference in Chicago as part of its 2019 review on monetary policy strategy. One of the Fed’s “mandates” is to ensure price stability – i.e., low, stable inflation. In 2012, the Federal Open Market Committee (FOMC) publicly declared a target annual inflation rate of 2.0 percent for the first time. However, the central bank repeatedly failed to sustain that level for most of the 10-year post-recession period. As shown in the graph below, core personal consumption expenditures (PCE) – the Fed’s preferred price index that excludes goods with volatile prices like food and energy – mostly remained below 2.0 percent between June 2009, the official end of the Great Recession, to May 2019. Headline PCE inflation averaged 1.5 percent over this period, while core PCE inflation averaged 1.6 percent.

Pairing this with President Trump’s trade war with China, which threatens to impede global growth and mute inflation even further, the Fed may consider decreasing interest rates to bolster price growth. This multi-faceted decision was the focal point of the Fed’s aforementioned conference, where Chairman Jerome Powell and other decision-makers and experts discussed the future of Fed policy in a low-rate, low-inflation environment. The possible decrease in interest rates could lead to new opportunities in the ARM industry as borrowers take advantage of reduced costs.

Fed officials must decide whether to lower interest rates in order to push inflation to their 2.0 percent target or leave rates unchanged in the hope that the current trend of soft price growth is merely “transitory” as Chairman Powell suggested in a recent press conference. One factor that could influence the Fed’s decision is the possibility that the central bank adopt a strategy of average-inflation targeting, through which the Fed would allow for prices to rise at a faster pace than 2.0 percent during economic expansions in order to offset lagging periods during downturns. The likelihood of a rate cut would dramatically rise should the Fed choose to pursue such an approach. Some experts have warned against loosening monetary policy, however. Adam Posen, head of the Peterson Institute for International Economics, stated the biggest concern behind rate cuts and quantitative easing is that during the next recession, there will be less room to bolster the economy as rates will already be too low for the Fed to make substantial changes before hitting zero.

In addition to these concerns, the Fed’s economists model that the neutral interest rate – the natural rate of interest that supports the economy at full employment while keeping inflation constant – has steadily decreased over the past 20 years. The graph below illustrates changes in the federal funds rate which the Fed uses to influence interest rates throughout the economy, including the drastic reductions, during recession periods, which are highlighted in red. In the wake of the Great Recession, the Fed lowered rates to nearly 0.0 percent, which lasted until the end of 2016. The federal funds rate steadily increased thereafter but remains far less than pre-recession levels. In the 1990s, the nominal neutral rate was estimated to be 2-2.5 percent, however, the Fed now puts it at 0.5-1.5 percent. The real neutral rate, which is calculated by adding the inflation rate to the nominal neutral interest rate, would be around 2.5 percent to 3.5 percent, assuming a rate of 2.0 percent inflation. This would make rate cuts of 4.0 percent to 5.0 percent, which occurred during previous recessions, impossible. To account for this, however, a recent San Francisco Fed Letter suggests that bankers may be open to the idea of a negative interest rate in this scenario with a lower bound of roughly -0.8 percent, which, if utilized during the Great Recession, may have resulted in a faster recovery.

Lower interest rates could benefit the ARM Industry overall. Due to a reduction in the borrowing costs, consumers may increase their utilization of credit cards, mortgage financing, and home equity lines of credit (HELOCs). The rise in the number and volume of credit accounts may lead to greater delinquencies and defaults due to consumer over-leveraging. Additionally, borrowers taking out adjustable-rate mortgages due to lowered rates may be less likely to repay their debts when the interest rate increases again. This would directly lead to a greater number of collection opportunities for ARM companies, especially those servicing financial institutions. On the other hand, if the cost of borrowing decreases, then consumers – especially those with variable-rate loans – will be able to repay their debts more often.

Additionally, credit card rates, which are determined by the prime rate, are closely correlated with the federal funds rate. Though each bank controls its own prime rate, with the average consistently hovering around 3.0 percentage points above the federal fund rate, the two metrics mostly fluctuate similarly. A lowered federal funds rate, along with consumers’ increasing reliance on credit cards to fund expenditures, would result in expanded credit card loans. This may drive delinquencies as well, thereby creating more opportunities for collectors.