Fed rate hikes beginning to pinch economy

Martin Wolk Chief economics correspondent • Profile • E-mail

The Federal Reserve, which has been battling against inflation for two years, is beginning to take some casualties. The economy, while still healthy, is sagging slightly under the accumulated weight of 17 straight interest rate hikes. Now it is up to Chairman Ben Bernanke, who is struggling to establish his credibility on Wall Street, to make sure the Fed does not overdo the rate-hike campaign and force the economy into an unwanted slowdown.

When the Fed began raising rates under then-Chairman Alan Greenspan in June 2004, the benchmark overnight lending rate was at 1 percent — its lowest level in nearly a half-century. It was easy money that helped fuel a boom in housing and consumer spending on big-ticket items, and each quarter-percentage point increase seemed barely perceptible to most consumers and business executives.

But two years later, the overnight rate is at 5.25 percent, and the cumulative impact is increasingly apparent across the most rate-sensitive segments of the economy, including housing, automobile sales and financial markets.

The most obvious impact is in the housing sector. Home sales and construction are slowing and there is every sign the boom will continue to fade, with mortgage applications declining, delinquencies rising and builder sentiment falling sharply.

Although mortgage rates did not initially rise in response to the Fed's rate hikes in 2004, they eventually began moving higher. Now the 30-year benchmark mortgage rate stands at about 6.75 percent, compared with under 5.5 percent two years ago. That is making homes less affordable to new buyers and cutting into home-price appreciation.

For people who already have homes, the bill is just beginning to come due, said Greg McBride, senior financial analyst with Bankrate.com.

“Another quarter-point move sounds like the same old story, but the reality is a lot of borrowers are going to see big payment increases as a result,” he said.

Many borrowers who locked in relatively low rates with adjustable-rate mortgages three to five years ago are about to get a shock, he said. For example, a borrower with an $200,000 adjustable-rate loan that closed in 2003 with a three-year lock could see his monthly payment rise by $430 when it adjusts upward. That is money that will no longer be available for gas, food or other consumer needs.

Interest rates on credit cards and other consumer loans have climbed steadily higher, and while consumers generally are not making higher monthly payments, they are having a harder time paying down their balances, McBride said. “It's like pedaling a bicycle in a stiffer headwind,” he said.

Home equity loans, a crucial engine for consumer spending in recent years, also have lost their luster, since rates are closely correlated to the Fed's moves. The home equity loan has suffered the “death of a thousand paper cuts,” McBride said, as rates have edged higher and higher. In any case, home price gains have moderated significantly — another secondary effect of the Fed's rate-hike campaign — so homeowners have less spare equity to borrow against.

Industry leaders have long said that the double-digit home price increases of the past several years were unsustainable, but in recent weeks they have begun to cry “Uncle.”

“This is a time for the Fed to pause on rate hikes because we have some interest-sensitive housing markets that have become vulnerable,” David Lereah, chief economist for the National Association of Realtors, said in early June.

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