Rate Cuts & Consumers: Will the Medicine Take?

Typically, a rate cut from the Federal Reserve reduces financing costs for consumers, thus freeing up cash flows which can then be a tailwind for spending. In this cycle however, the expansion in household debt has not occurred in variable rate categories—adjustable-rate mortgages or credit card spending—which would see the greatest benefit. Instead, the growth in household debt has been entirely in two categories: student and auto loans (Figures 1 & 2), where rates are typically fixed and do not move in lockstep with the fed funds rate.

It is widely expected that the Federal Open Market Committee (FOMC) will cut the federal funds rate at the conclusion of this week’s policy meeting. There are a number of different ways it could approach policy, which makes this one of the most anticipated meetings in recent memory.1 Whatever the Fed decides, it has been steering expectations in the direction of more accommodative policy. Lower rates will still be helpful to some households, but due to the composition of household debt growth in this cycle, we should not expect as much of a boost to household finances from a rate cut compared to prior cycles.

The point of this report is to gauge the impact on consumer spending of a lower rate environment, but it bears noting that the consumer is already on pretty solid footing. Personal consumption expenditures (PCE) rose a solid 4.3% annualized in the second quarter, the fastest pace since Q4-2017. Household debt is rising, but as a share of disposable income and as a share of the economy, it remains well-below levels seen prior to the financial crisis. Household debt service and financial obligation ratios also remain near historically low levels, suggesting the debt burdens of households appear to be largely manageable. There appears to be no glaring need at present for easier monetary policies to boost consumer spending.

Mortgages: ARMs Need a Leg Up

In prior economic cycles, a drop in the fed funds rate quickly translated into lower payments on mortgages and credit card debt. But because homeowners are financing their purchases differently and consumers have been less apt to reach for the plastic in this cycle, there may be less of an immediate boost for consumer finances from rate cuts.

To be clear, consumers with an adjustable-rate mortgage may be in store for some relief as lower rates equate to lower interest payments. Still, the economic benefits to the housing sector from rate cuts will likely be muted compared to prior cycles. Most homebuyers today are opting for fixed-rate mortgages—adjustable-rate mortgages account for only about 5% of total mortgages outstanding today, compared to roughly 30% of mortgages prior to the last recession (Figure 3). Moreover, mortgage rates in general tend to track more closely with the yield on the 10-year Treasury than the fed funds rate (Figure 4), which limits the direct effect the Fed can have on mortgage financing costs. So while some homebuyers with adjustable-rate mortgages have benefitted from the recent decline in the 10-year yield, the majority of borrowers who today have a fixed-rate mortgage will not see a change in their monthly payment from lower rates.

Another factor to consider here is that high mortgage rates are not the primary obstacle to home purchasing; that role goes to the low supply of affordable homes. Rate cuts will not address that issue. So while lower rates may ease the mortgage burden of some households, we do not see a lower rate environment engendering a surge in demand for new home purchases. Furthermore, while mortgage debt still accounts for a majority of total household debt, it is down both in total amount outstanding and as a share of total household debt throughout this cycle.

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