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Who's Hurt By Rate Hikes? Hint: It's Not The Rich



When Federal Reserve Board officials meet on Nov. 15 to consider yet another interest-rate hike, they will carefully weigh the benefits of damping inflation vs. the costs from slowing growth. They probably won't give more than a fleeting thought to how higher interest rates affect families in different income brackets and actually change the distribution of income in the economy.

But they should. The evidence is overwhelming that higher interest rates hurt the middle class a lot more, because it shells out a greater portion of its income in interest payments than do the affluent. They also benefit the middle less because it owns a smaller share of the nation's interest-earning assets. The opposite is true for the affluent. Sure, a rate hike depresses the value of many financial assets, such as bonds that fall in price as rates rise. So the portfolios of the well-off are worth less when rates spike. But this is only in the short run. Over the longer haul, the gains in interest income from higher rates outweigh any short-run losses.

UNEQUAL IMPACT. To make matters worse, raising interest rates also exacerbates the already widening gap between income classes. While the top 20% of families have seen their real incomes rise in recent years, the incomes of the remaining 80% of families have fallen. So Fed tightening hits hardest at those who have less to spend. "From the Fed's standpoint, interest rates are the only lever it has," says David A. Wyss, an economist at DRI/McGraw-Hill. "But that's the wrong lever right now" from an equity standpoint.

Economists and policymakers have long worried about the unequal impact of Fed policy. However, they usually focused on the unemployment it typically produces, which strikes first and hardest at blue-collar and low-income families. The lack of attention to income distribution may have been justified in the past, when most people's income was rising. But that's no longer true, so higher rates have a more disparate impact.

Economists say that in judging the burden of higher rates, the key is not the actual amount of dollars spent but rather the percent of family income that those dollars make up. So although the 7% of households earning $100,000 or more a year have two to three times as much mortgage and credit-card debt as other households, they spend only 12% of their annual income on all types of debt, according to the Fed's Survey of Consumer Finances (tables). By comparison, middle-class families shell out up to 20%. The poor spend less, about 16%, primarily because many don't own a home and lack access to credit.

BIG GAINERS. To be sure, the aggregate numbers appear to show that all households gain from rising rates, because they receive more in interest than they pay out. The total amount of interest-bearing assets in the U.S. exceeds the value of interest-bearing liabilities by as much as 50%, according to a 1988 study by Fed economist Charles A. Luckett and two colleagues. Similarly, households' interest income surpassed their interest payments by 10% to 50% for almost every year since World War II, Luckett found.

But that's very deceptive. Affluent families are the big gainers, while those on the lower rungs are losers. The top 7% of households own 60% of the nation's bonds and 31% of all other interest-bearing assets, according to an analysis of Fed data by New York University economics professor Edward N. Wolff. As a result, taxpayers in the top 7% rake in nearly 40% of all interest income, according to Internal Revenue Service data.

Of course, the gains of the affluent can be offset by other effects of Fed tightening. Because stock and bond prices typically fall when rates rise, the value of wealthy families' assets drops. But that's only part of the story. The affluent get a stream of income from their financial assets, which they can reinvest in more lucrative investments when rates go up. Over time, they can't help but come out way ahead from an increase in interest rates. Of course, poor and middle-class households could in theory invest at the same higher rates. But in practice, they simply don't have the capital. Indeed, they are net debtors, so an increase in rates actually lowers the amount of disposable income that they have available for new investment opportunities.

The elderly probably are net creditors, too. People 65 and over invest more in interest-bearing assets than those in other age groups. They also pay less in debt--about 10% of their family income--than younger families, according to the Fed. "There's no question that all those elderly coupon clippers in Florida are happy when rates go up," says Donald Ratajczak, an economist at Georgia State University.

"FRIGHTENING." Soaring inequality has exacerbated the Fed effects. The gap between high- and low-income families has widened steadily since about 1980, hitting a new high every year since 1985. Last year, the top 20% pulled in a record 46.2% of national income. This was a 1.6-percentage-point leap from 1992, the largest jump since the Census Bureau began keeping track in 1947. As a result, median family income fell 1.9% after adjusting for inflation, even though the economic recovery generated a healthy 1.8% spurt in real per capita income, according to the Census Bureau. And this was no one-time blip: Median family income has fallen 7% behind inflation since 1989. "All of the growth last year went to the top 20% of families," says Larry Mishel, chief economist at the Washington-based Economic Policy Institute.

In this context, Fed rate hikes undercut the spending of families that already are earning less. "The notion that the Fed wants to tighten when the average family is losing ground is a little frightening," says Harvard University economist Lawrence F. Katz.

It's also likely that the signals of soaring demand worrying the Fed stem primarily from more affluent households. Spending and consumption patterns closely paralleled the jump in income inequality in the 1980s, according to a 1991 analysis of Census data by Katz and Harvard economics professor David M. Cutler. Indeed, the bottom 30% of individuals actually spent and consumed less, in inflation-adjusted dollars, in 1988 than in 1980, they found. The top fifth gained about 20% during this period. The Census data from 1988 to 1992, the latest year available, show a similar pattern of spending inequality.

With the economy humming along, the Fed may feel that it has no choice but to jack rates up again. If it does, it's the middle class who will once again take the biggest hit.Aaron Bernstein in New York

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