Susan Schmidt Bies: The economic outlook and financial health of bank
customers
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Economic Growth and Regulatory Paperwork Reduction Act Banker Outreach Meeting,
Nashville, Tennessee, 22 April 2004.
* * *
I am delighted to be back in Tennessee today and to have a chance to visit with some old friends. I
also want to thank you for giving so much of your time to help us identify ways to reduce unnecessary
and unduly burdensome regulatory requirements on financial institutions. There is a real need to
continually review the cost-benefit nexus of regulations, especially with the fast pace of evolution in
financial markets and institutions. Thus, my colleagues in the Federal Reserve System and I are
strong supporters of the goals of today's meeting. It is a critical supplement to our own efforts, which
include a review of our regulations every five years to revise or rescind out-of-date or unnecessary
rules.
I thought that after lunch you might find it interesting to shift to a discussion of the financial health of
bank customers and the economy. In that spirit, I would like to briefly share with you my assessment of
the economic outlook and then to discuss in more detail how the evolution of household and business
balance sheets in recent years is affecting economic activity. You should understand, however, that I
am expressing my own opinions, which are not necessarily those of my colleagues on the Board or on
the Federal Open Market Committee.
The economic outlook
As you know, real GDP grew at an annual rate of 6.2 percent in the second half of 2003, and the
economic fundamentals seem to be in place for another sizable advance this year. Indeed, the central
tendency range of FOMC-member forecasts is 4-1/2 to 5 percent. Yet despite the recent strong pace
of economic activity, the labor market has improved at an unusually slow pace by historical standards.
The most recent data - indicating a jump in payrolls in March - was good news, and I am cautiously
optimistic that job growth will pick up further over the remainder of this year. My business contacts tell
me that companies have become more optimistic about economic prospects and that their plans do
include increases in the size of their payrolls.
The latest data on consumer prices suggest that the process of disinflation may have come to an end.
In March 2004, the twelve-month change in the core CPI rose to 1.6 percent - essentially the same
pace as in March 2003, and the core PCE price index change from twelve months earlier moved back
above the 1 percent level in both February and March. Although the increased pace of economic
activity has put some upward pressure on prices at earlier stages of processing and higher energy
prices are being passed through to the prices of some products, strong productivity growth and slack
in resource utilization have kept core retail price increases in check.
Household financial conditions
Some commentators have expressed concern about the rapid growth in household debt in recent
years, fearing that households have become overextended and will need to rein in their spending to
keep their debt burdens under control. My view, however, is considerably more sanguine. Although
there are pockets of financial stress among households, the sector as a whole appears to be in good
shape.
As bankers, you are well aware that households have taken on quite a bit of debt over the past several
years. According to the latest available data, total household debt grew at an annual rate of 10 percent
between the end of 1999 and the fourth quarter of 2003; in comparison, after-tax household income
increased at a rate of 5 percent. But looking below the aggregate data, we must understand that the
rapid growth in household debt reflects largely a surge in mortgage borrowing, which has been fueled
by historically low mortgage interest rates and strong growth in house prices.
Indeed, many homeowners have taken advantage of low interest rates to refinance their mortgages,
some having done so several times over the past couple of years. Survey data suggest that
homeowners took out cash in more than one-half of these "refis," often to pay down loans with higher
interest rates. On net, the resulting drop in the average interest rate on household borrowings,
combined with the lengthening maturity of their total debt, has tempered the monthly payment
obligations from the growing stock of homeowners' outstanding debt.
The Federal Reserve publishes two series that quantify the burden of household obligations. The first
series, the debt service ratio, measures the required payments on mortgage and consumer debt as a
share of after-tax personal income. The second series, the financial obligations ratio, is a broader
version of the debt service ratio that includes required household payments on rent, auto leases,
homeowners' insurance, and property taxes. Both ratios rose during the 1990s, and both reached a
peak in late 2001. Since then, however, they have receded slightly on net from their respective peaks,
an indication that households, in the aggregate, have been keeping an eye on repayment burdens.
Because the debt service ratio and the financial obligations ratio are calculated from aggregate data,
they do not necessarily indicate whether the typical household is experiencing financial stress.
Nonetheless, we have found that changes in either ratio help predict future changes in consumer loan
delinquencies. Accordingly, the fact that these ratios have come off their recent peaks is a hopeful sign
about household loan performance. Indeed, delinquency rates for a wide range of household loans
turned down over the second half of 2003.
Another often-cited indicator of household financial conditions is the personal bankruptcy rate.
Movements in the bankruptcy rate, to be sure, partly reflect changes in the incidence of financial
stress, but the rate has been trending up for more than two decades for a variety of other reasons. The
Bankruptcy Reform Act of 1978 made bankruptcy a more attractive option for most households by
increasing the amount of wealth that households could retain after bankruptcy. Other factors that have
likely contributed to the upward trend are the decrease in the social stigma of filing for bankruptcy and
the growing access to credit in the United States. As lenders have become more sophisticated in their
ability to assess the riskiness of borrowers, they have extended loans to households that were
previously denied credit. These households are more likely to default on their obligations than the
typical borrower, but this increased risk is priced into loan terms. Although the bankruptcy rate remains
elevated, it has edged down on balance in recent months, likely because of the pickup in economic
growth in the United States since mid-2003.
This relatively upbeat assessment of household credit quality seems to be shared by lenders and by
investors in securities backed by consumer debt. According to the Federal Reserve's survey of senior
loan officers, the number of banks tightening their standards on consumer loans has fallen over the
past year. This behavior certainly does not point to much concern about household loan performance.
Moreover, one gets an even more positive message from the credit spreads on securities backed by
auto loans and credit card receivables. In recent months, the spreads between the yields on these
securities and swap rates of comparable maturities have narrowed across the credit spectrum.
Thus far, I have focused on the liability side of the household balance sheet, but there have been
favorable developments on the asset side as well. Equity prices rallied strongly last year and have
continued to rise this year, reversing a good chunk of the losses sustained over the previous three
years. In addition, home prices appreciated sharply during each year from 1997 to 2003. The
cumulative rise since the late 1990s has exceeded the growth in per capita income by a wide margin.
All told, the ratio of household net worth to disposable income - a useful summary of the sector's
financial position - recovered last year to stand at a level about equal to its average over the past
decade.
Before I turn to the business sector, let me address the frequently expressed concern that a bubble
may have developed in house prices after several years of rapid increases. Some of the measured
price rise results from improvements in the quality of houses. Houses are bigger and have more
amenities than in the past, two characteristics that will lead to rising average house prices over time.
But even after one controls for quality, increases in home prices have been outstripping general price
inflation by a considerable margin in recent years.
Once again, the low interest rates are probably an important factor. Houses, like other assets,
generate an expected stream of future benefits. With low interest rates, these future benefits are
discounted less heavily, which raises the asset's price today. Low interest rates also push up house
prices by boosting the demand for housing. Of course, some of that increased demand is being met by
the rapid pace of construction of new housing. But building houses takes time, and in the interim,
higher demand will push up the price of existing houses.
Although we can identify the key forces behind the rise in house prices in recent years, we cannot be
sure that the increases are fully justified by the prevailing fundamentals. Still, we need to keep the
recent increases in house prices in perspective: Although house prices have been outstripping broad
measures of inflation - even after adjusting for quality improvements - their rise is nothing like the
increase in stock market prices in the late 1990s.
In fact, the speculative forces that can sometimes drive equity prices to extremes are less likely to
emerge in housing prices. First, buying and selling houses is a lot more expensive and cumbersome
than buying and selling equities, which makes taking a speculative position in houses much more
difficult. Second, housing markets are much more local than equity markets, which are national, if not
global, in scope. So if any speculative frenzy emerged, it would be much less likely to spread in the
housing markets than in equity markets. Finally, financial institutions have a much more disciplined
process regarding the housing and construction lending market than they did in past housing cycles.
Lenders today are cautious about lending for speculative purposes, and appraised values undergo
more scrutiny than in the past. The expansion of credit to higher risk households may also have driven
banks to strengthen their underwriting procedures.
That said, local housing markets can certainly become overvalued and then experience sharp price
declines. House prices fell significantly in several parts of the country in the early 1990s. But because
the transactions costs are much higher in the housing market than in the equity market and because
the underlying demand for living space is much more predictable than are the prospects for any given
firm, the large increases and decreases often observed in the stock market are less likely to occur in
the market for houses. In addition, lenders are much more responsive to local economic conditions
and generally become more cautious in loan underwriting when unsold homes or local unemployment
increase.
Financial conditions of businesses
The change in the economy that caught my attention in the second half of 2003 was that the decline in
business fixed investment had finally ceased. Capital spending by businesses posted a solid increase
in the second half of last year, and orders and shipments for nondefense capital goods - key indicators
of equipment spending - point to further sizable gains. Moreover, the tenor of anecdotes from the
corporate sector has become comparatively upbeat, with corporate managers seeing stronger revenue
growth and a much improved and more accommodative financing environment.
Four factors have contributed to this improvement in financial conditions: low interest rates, a
widespread restructuring of corporate liabilities during the past few years, a sharp rebound in
corporate profitability from its trough in 2001, and a substantial narrowing in market risk premiums. In
addition, the burden of underfunded pension plans, perhaps the most prominent negative financial
factor that remains, has eased of late. I will discuss each factor in turn.
First, firms are continuing to benefit from the accommodative stance of monetary policy. With the
federal funds rate at 1 percent, short-term borrowing costs remain very low. For longer-term debt, the
combination of low yields on benchmark Treasury securities and reduced risk spreads has kept
borrowing costs attractive. Indeed, the yield on Moody's Baa corporate bond index is at its lowest
sustained level since 1968.
Second, in response to low long-term rates and to investors' concerns arising from some high-profile,
unanticipated meltdowns, firms have greatly strengthened their balance sheets. Many firms have
refinanced high-cost debt, which has reduced the average interest rate on the debt of nonfinancial
corporations more than 1 percentage point since the end of 2000. Businesses also have substituted
long-term debt for short-maturity debt to improve their balance sheet liquidity and to reduce the risk of
rolling over funds. In addition, many firms - especially in the most troubled industries - have retired
debt through equity offerings and asset sales, which limited the growth of nonfinancial corporate debt
in 2002 and 2003 to the slowest pace since the early 1990s.
Third, firms have significantly tightened their belts. Over the past two years, the drive to cut costs has
generated rapid productivity gains. This greater efficiency boosted corporate profitability in 2002 and
2003 despite rather tepid revenue growth. Moreover, a pickup in revenue growth in the second half of
last year helped companies leverage those productivity gains, producing a dramatic recovery in overall
corporate profitability. Over 2003, economic profits before tax surged more than 18 percent, bringing
profit margins to their highest levels in several years.
Fourth, risk premiums fell substantially last year as corporate governance scandals receded and
investor sentiment turned markedly more positive. The recovery in stock prices reflects this brighter
view. Spreads on corporate bonds have narrowed appreciably - especially for the riskiest firms - and
they now stand at the lowest levels in several years. This decline in spreads has been helped by the
beneficial effect of the balance sheet improvements that I mentioned a moment ago. Indicators of
corporate financial stress, such as bond rating downgrades and default rates, have returned to levels
normally associated with economic expansion. Delinquency rates on business loans at commercial
banks have also declined, and our surveys indicate that, on balance, banks have recently eased the
terms and standards on such loans for both large and small firms.
Another sign of improved sentiment is that money has been flowing into riskier securities. For
example, net inflows to equity mutual funds have been strong for about a year, and high-yield bond
funds, too, registered strong net inflows in 2003. Junk bond issuance has picked up notably, and the
market for initial public equity offerings has also shown signs of recovery, while investors still appear to
be more selective than during the boom in the late 1990s.
These four points all suggest that financial conditions are capable of supporting a sustained, healthy
pickup in economic growth. The much improved profitability can help finance expansion directly out of
internal funds or indirectly by supporting firms' borrowing capacity. Furthermore, firms will be able to
draw on their liquid assets that have accumulated over the past couple of years. And given the
successful efforts to pare costs, firms are set to benefit from new investment in plant and equipment.
Perhaps the biggest financial hurdle still facing many corporations is the burden of underfunding in
their defined-benefit (DB) pension plans, but even here we have seen some improvement. Stock
market losses during 2000 to 2002 had significantly eroded the value of pension assets, while sharply
declining interest rates had raised the current value of plan liabilities. As a result, the majority of S&P
500 plans were underfunded at the end of 2002, with a net shortfall that exceeded $200 billion. Thus,
many companies needed to make additional contributions, in some cases quite substantial, to their
pension plans. In 2002, S&P 500 firms contributed $46 billion to their pension plans - three times more
than in either of the previous two years - and total contributions are estimated to have been even
higher in 2003.
This drain on corporate sponsors' cash resources is likely to ease in the near term, but longer-term
issues remain. DB pension asset values have benefited from robust returns in equity markets since
early last year. And earlier this month the President signed legislation that allows firms to reduce plan
contributions for two years by permitting them to use a corporate bond rate rather than a Treasury
bond rate to calculate liabilities. But beyond the near-term, firms with DB pensions tend to be in
maturing industries with aging workforces, for which the growth of liabilities are high and rising. This
longer-term challenge will remain even if the current favorable market conditions are sustained.
Conclusion
In summary, recent indicators suggest that the pace of economic activity remains solid, while
inflationary pressures continue to be subdued. In addition, the household and business sectors are, by
and large, in good financial shape. Although uncertainties remain, I believe that the fundamentals are
in place to generate sustainable economic growth.