The conventional wisdom was that the Federal Reserve would again hike short term interest rates today. That wisdom proved correct, as did the prediction that the Fed would say it is committed to further hikes.
The conventional explanation is that slightly higher interest rates, by making borrowing more expensive, will keep the economy from overheating. Isn’t that correct as well?
Well, yes. But let us not forget the downsides of higher interest rates.
The most obvious: that the Fed will slow the economy too much. This is presumably why this summer, President Donald Trump, in a characteristically untraditional intervention for U.S. presidents, chided the Fed for raising rates.
“I’m not thrilled with his raising of interest rates, no. I’m not thrilled,” he said after the last rate hike, in August.
The Fed should do “what’s good for the country,” Trump said according to an interview with Reuters. “I should be given some help by the Fed.”
The Fed, of course, is trying to steer the time-honored middle course between an extreme slowdown or even recession that Trump fears and an economy on a binge that will fuel inflation that threatens to spiral out of control — in the words of a long-ago Fed chairman the aim is “to take away the punch bowl just as the party gets going.”
But there are other concerns about higher interest rates as well. For one thing, a whole lot of past borrowing will be put at risk. Many adjustable-rate mortgages are tied to the Fed rate, for example, and though the gimmicky mortgages that helped trigger the financial crash of ’08 are no longer in vogue, millions of Americans will see their mortgage payments rise if interest rates do.
More broadly, the McKinsey Global Institute has estimated that something like $3 trillion worth of U.S. corporate debt will have to be refinanced in the next five years. Much of that debt is already rated as risky enough to qualify for the designation “junk bonds.” Higher interest rates mean higher borrowing costs and therefore an increased risk of default.
Within the corporate sector, the famously thriving private equity industry would be especially vulnerable if interest rates rise.
According to the Wall St. Journal last month:
“Investors bought record amounts of junk-rated corporate loans in recent years, betting they would deliver more stable returns than high-yield bonds, but the loans are no longer as safe as their owners may think. A rapid deterioration in the quality of “leveraged loans” means loan holders would recover far less in a future economic downturn than they have historically.”
And here’s New York Post columnist Josh Kosman, the author of The Buyout of America.
“If interest rates rise and stay elevated for the next several years there could be serious problems,” Kosman said in an email. “The dollar value of highly leveraged loans for U.S. issuers is at record levels. Last year, U.S. companies borrowed $919 billion in highly leveraged loans, more than double the $412 billion in 2016. Roughly 60 percent of the money has been borrowed by private equity firm-owned companies.”
This is partly because these loans are being packaged into securities known as Collateralized Loan Obligation funds.
“Every Collateralized Loan Obligation consists of a little bit of debt from perhaps 150-200 different loans, the idea being that if one of these pieces of debt fails, the others can make up the difference,” Kosman said.
But a similar security product, known as collateralized debt obligations, also promised that sort of supposed diversification. The false sense of security they provided was instrumental in the meltdown of the mortgage market a decade ago.
“Debt multiples too are as high as they were in the prior 2006-08 boon,” Kosman said.
No, I’m not predicting the financial crash of ’18 because the Fed hiked short-term interest rates one-quarter of a percent. Consider this nothing but a reminder that seemingly sensible economic policy can have unintended consequences.
Editor’s note: This story has been updated to reflect that U.S. companies borrowed $412 billion in highly leveraged loans in 2016, not 2017.