Thursday, June 10, 2010

Why households would benefit from higher interest rates

Today the Federal Reserve released its first quarter '10 estimates of U.S. Households' Balance Sheets. As shown in the bottom chart, Household Net Worth rose by $1 trillion during the period, driven mostly by a rise in equity prices. I note that there was yet another reduction in Household Debt, which has been declining for the past three years, and a marginal $27 billion reduction in the value of real estate holdings, which has declined by over $7 trillion since its peak in 2006. Separately, it is comforting to see that disposable personal income reached a new all-time high ($11.1 trillion). On balance, the data reflect a year-long improvement in the financial health of the nation's households.

I've disaggregated the Fed's data in order to estimate how much exposure households have to fixed and floating rate debt (top chart). The most important result is that households have far more floating rate assets (e.g, about $10 trillion of bank CDs and money market funds) than floating rate liabilities (e.g., about $2.6 trillion of adjustable rate mortgages and about $2 trillion of other short-term debt subject to rising rates). If interest rates were to rise as a result of an unexpected Fed tightening, household cash flow would immediately benefit because the increase in interest received would exceed the increase in interest paid out.

As for exposure to fixed interest rates, households would suffer somewhat from higher interest rates, since they have about 20% more exposure to fixed rate assets (mainly in the form of bonds whose price would decline as prices rise), than they do to fixed rate debt (mainly in the form of fixed rate mortgages that would be immune to higher interest rates). However, this loss would be only on a mark-to-market basis, since cash flows would be largely unaffected.

I should note that aggregate exposure to changes in interest rates is mostly a zero-sum game. Households would benefit from higher interest rates because of their very large cash holdings, but institutional investors and foreign holders of Treasury debt that have little in the way of cash, for example, would lose.

1 comment:

skydude said...

Great post.

I have referred back to this post several times. I just didn't get around to typing a thank you note.

So thanks!