The U.S. Economy
Fed officials opted to continue the tapering trend at their March meeting. For the third time since December the committee decided to trim $10 billion from the current quantitative easing (QE) program. As with the two prior QE cuts, the latest involved equal reductions in the amount of agency mortgage backed securities and long-term Treasury securities that are being added to the Fed balance sheet each month. Though incrementally weaker relative to the last few months of 2013, economic reports so far in 2014 were judged by the Fed as indicative of economic progress sufficient to warrant continued QE unwinding.
Newly minted Fed Chairwoman Janet Yellen raised eyebrows during a post meeting press conference when she made a statement pertaining to the timing of the first interest rate hike. Responding to a question about the “considerable time” language the FOMC has used in its press releases describing how long the committee expects to keep interest rates low after QE ends, Yellen said, “something on the order of six months.” If QE ends during the fourth quarter of this year, her statement suggests that rates would begin to move higher earlier in 2015 than investors were expecting. U.S. stocks promptly declined on the remark, but were generally able to recoup those losses by month-end.
The forward guidance policy tool is one the Fed will continue to use as it begins to slowly tighten monetary controls in the future. The market is very aware of this, and investors’ attentiveness is a key reason markets cracked so quickly on Yellen’s comment. That being said, we are hesitant to take her statement at face value as the Fed continues to champion the idea that policy decisions will be data dependent. When policymakers decide to lift interest rates it will be because the data supports doing so, not simply because six months had passed since QE ended. To this end, it is worth noting that the FOMC dropped the specific 6.5% unemployment rate threshold they had previously said was among data points that would prompt policy adjustment.
Fed officials and investors alike remain keenly focused on lending growth. Acceleration in loan disbursements would be a signal that reserves in the banking sector are making their way into the economy and this could spur inflationary pressures. So far there is little evidence of this as overall lending is still expanding fairly slowly. That being said, the distinct acceleration in the student loan debt category in particular is getting a lot of attention in the media.
Recent anecdotes about individuals enrolling in higher education, not for the learning experience, but in order to qualify for loans that are then used to pay normal living expenses, are an indication that future problems may be brewing. These stories surface at the same time that student loan quality metrics continue to deteriorate.
Our analysis suggests that problems in the student loan arena, even if severe, would not create the far-reaching calamity in financial markets and economies that the housing crash did. Federal government programs are responsible for the vast majority of issuance in the student loan market and government guarantees stand behind the bulk of outstanding student loans today. Student loans are also not dischargeable in bankruptcy. In contrast to the pre-housing crisis mortgage market, student loan asset backed debt is relatively small and its tentacles do not extend into far-reaching corners of financial markets as housing debt and its many derivative investment products did.
Rising student loan delinquency rates are something to watch, but we think the education lending phenomenon’s real economic impact will come in the form of delayed household formations and lower consumption among younger demographic cohorts that hold the debt, as opposed to cascading loan defaults that ultimately shutter credit markets as was the case in housing. Moving through the economic cycle, it is natural for loan quality metrics on most types of credit to deteriorate as lending standards get looser and borrowers feel comfortable taking on more debt.
The housing crisis taught investors the importance of understanding what’s causing borrowers to miss payments, and perhaps above all, how missed payments or outright default could impact the value of securities that are tied to the underlying loan. Our research suggests that the upward trend in delinquencies in the student loan arena is primarily the result of poor underwriting and oversight by government entities that issue the loans. Insofar as other new borrowers attempt to take advantage of the system and withdraw loans they do not intend to use for educational purposes, student loan quality metrics may continue to worsen going forward.
We do not expect trends in the student loan arena to manifest as a meaningful downside risk to our slow economic growth outlook, but rather that the student loan situation is one of several factors that should continue to act as a preventative force against economic acceleration.