One of the most often-cited rationales for the Fed to begin raising interest rates is that it will supply banks with a justification for increasing consumer loan rates, which will cause net interest margins (NIM) to increase at the banks, which will cause banks to become more aggressive in making loans. Simultaneously, as the theory goes, consumers will respond by increasing their borrowing before the rates head even higher. This increased lending activity and associated liquidity will allow for incrementally looser lending standards, which will in turn pull other consumers into borrowing, which will cause economic activity to increase and the virtuous cycle of consumption, production, job and income growth to begin.
The transmission for such is roughly that higher short-end loan rates and Treasury yields caused by the Fed increasing the overnight lending rate will cause 1) consumer loan rates tied to short-end rates, principally auto and revolving credit facility rates, to increase, thus pulling future demand into the present, and 2) that higher short-end rates will cause bond holders to shift to shorter maturity issues from longer term, which will cause long-end yields, especially the 10-year Treasury yield, to increase. This will drive up the cost of consumer loan rates tied to long-end rates, principally residential mortgages, and that will cause consumers to rush to purchase a home before higher rates price them out of the market.
The two most important issues with respect to this theory are that in order for the process to work as intended, NIMs must already be low enough that the banks are not motivated to lend and that there is pent-up consumer demand that's not been motivated to borrow because a "paradox of thrift" has become ingrained in the consumer psyche as a result of loan rates being low for several years, and has demotivated potential borrowers from actualizing that borrowing.
In essence, the theory is that a bid-to-ask spread has developed between lenders and borrowers, wherein the rate at which lenders are willing to lend, especially for residential mortgages, is higher than the rate at which borrowers are willing to borrow. The standoff between the two groups has gone on for so long, almost seven years now, that the Fed's zero-interest-rate policy has counterintuitively, counterproductively and unintentionally demotivated borrowers and is thus now the cause of economic stagnation rather than the opposite.
However, as auto loan rates have increased over the past few years, there's been an even faster deceleration in growth of auto loans and auto purchases, which implies that consumers are still rate-sensitive, will not respond well to increasing loan rates for mortgages, and that the "pent-up demand" and "paradox of thrift" arguments for raising rates are dubious.
I last discussed this issue in the column, "The Changing American Dream: From House to Car," and it's been exhibited as well by Ford (F), General Motors (GM), Toyota (TM), Honda (HMC) and Nissan (NSANY) all having negative two-year returns on their stocks. (Ford is part of TheStreet's Dividend Stock Advisor portfolio.)
Coming back to the NIM issue, although they have indeed steadily declined since the Fed funds rate target was lowered to 0%-25%, at the current industry aggregate rate of about 3%, they are very near where they were at the height of the housing bubble in 2006. Competition for the making of consumer loans precluded the banks from increasing their NIMs then, and it is most logical that the same ceiling would be caused to occur in the event that consumer loan taking, especially for mortgages, were to occur again.
It is also more probable that the hesitancy of banks and mortgage-backed securities (MBS) buyers to be willing to lower mortgage rates to the level at which marginal consumer demand would increase is that there is a fear of holding securities that would incur losses if rates rose.
The fear of rate increases that would cause losses to be incurred by the loan and MBS holders is being driven not by economic fundamentals but because the Fed has been telegraphing and promising that rates will be increasing.
The problem, of course, is that this prevents the loan activity and consumer activity that would cause economic activity to increase and warrant concerns about inflation by the Fed that would justify raising rates.
The bottom line right now is that the most probable reason the economy is not evidencing rates of inflation the Fed models indicate should be occurring is that the Fed has been attempting to stick to a narrative and timeline for raising rates that is not warranted by economic activity, and in so doing preventing the activity that would warrant raising rates.
