Households have been whittling away their debt since the Great Recession, particularly home mortgages. In particular, rising home values could give both mortgage borrowers and lenders the stimulus they need to take on/issue more debt.According to estimates from the Federal Reserve Bank of New York, households continued to deleverage their balance sheets in 2014. Consumer debt fell modestly from 67.5% of nominal GDP in Q4 2013 to 66.8% in Q4 2014. This added to the trend of consumer debt falling by over 20% with respect to nominal GDP after peaking at 87.1% in the first half of 2009.
The Great Household Deleveraging occurred mainly in mortgage debt, which fell from a peak of 68.5% of GDP in late 2008 and early 2009 to just 49% by the end of 2014. The decline in non-mortgage debt (auto loans, credit card debt and other consumer loans) fell more modestly from 18.6% of GDP at the end of 2008 to a low of 16.5% in mid-2012. Since then, it has rebounded to 17.8% of GDP (Figure 1).
To say that the economy deleveraged as a whole, however, isn’t accurate: while household debt came down, government debt soared. Federal debt grew from 35.2% of GDP at the end of 2007 to about 74.1% by the end of 2014 on the back of large deficits but was able to avoid a 1930-style implosion, while deleveraging by the household sector was bolstered by low interest rates.
As such, the combination of household + Federal debt increased from 126.4% of GDP at the end of 2008 to around 141% at the end of 2014 (Figure 2). That said, most of the increase happened by 2011 when the total household + Federal debt reached 139.5% of GDP. Federal debt is now rising rather slowly as a percentage of GDP because the Federal budget deficit has declined dramatically in recent years, from 10.1% of GDP in 2009 to just 2.8% in late 2014 and early 2015 (Figure 3).
Deleveraging by the household sector created a drag on growth as the housing sector collapsed and consumer spending grew more slowly than personal income, pushing the savings rate from about 3% of disposable income, on average, in the 2005-2007 period to about 6% from 2008 to 2013.
Now, however, household deleveraging seems to have mostly run its course. In fact, given the combination of rising labor income and low interest rates, it would not be surprising if the second half of the decade sees a re-leveraging by the household sector. Moreover, the combination of reduced debt and low interest rates has caused the cost of servicing household debt to fall to its lowest level since the Federal Reserve began tracking the series in 1980 (Figure 4). During Q4 2014, consumers spent just 9.9% of their incomes, on average, servicing their debt, down from a peak of 13.2% at the end of 2007.
Lower consumer debt and debt servicing costs, along with a recapitalized banking system, could lead to a change in psychology, boosting household borrowing and lending going forward. In particular, rising home values could give both mortgage borrowers and lenders the stimulus they need to take on/issue more debt. The S&P Case Schiller Index has recovered about two-thirds of its value lost during the housing debacle of 2007-2009 (Figure 5).
If the household sector does in fact begin to take on more debt, one should expect a continued rebound in consumer spending, home construction and tax revenues (including at the state and local levels) during the second half of the decade. This, in turn, should make it easier for the Fed to normalize interest rate policy by bringing its policy rate up to at least the level of core inflation, which is currently around 1.8% of GDP as measured by the CPI and 1.3% as measured by the core-PCE deflator.
Higher interest rates, of course, would serve to constrain growth in consumer spending and would also make it harder to reduce the Federal budget deficit as public and private sector interest costs would rise slowly over time. That said, we think the Fed is likely to take a gradual approach to normalizing interest policy (with a first rate hike sometime this year) and that a moderate pace of tightening is unlikely to produce an abruptly negative shock to the economy. Even if the Fed moves rates up to the level of core inflation, real rates will remain low by historical standards and should provide plenty of room for households to reverse the post-crisis deleveraging trend and begin to put more red ink on their balance sheets.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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