Can Consumers Cope with Higher Rates?

Though the Fed's hike is small, it could hurt millions of Americans already squeezed by rising prices and slow-growing wages

By Amey Stone

Time to wake up and smell the rate hike. The Federal Open Market Committee, the central bank's rate-setting arm, voted on June 30 to raise short-term interest rates by a quarter-point, from 1% to 1.25%. While professional economists and investors saw this one coming a mile away, for the average U.S. consumer, the reality of rising rates may just be coming into view.

For some people, particularly seniors on a fixed income, this hike -- and the two or three additional ones expected later this year -- will improve cash flow, thanks to higher yields on certificates of deposit and other savings vehicles. It will take about three to four weeks for money-market funds, now yielding 0.59% on average, to get to 0.75%, says Peter Crane, managing director of research firm He expects money funds to yield 1.75% by yearend. That's starting to be real money again. "They are clicking their heels down in Florida," says David Kelly, economic adviser to Putnam investments.


  Nonetheless, for many American families -- the great majority of which aren't in saving mode -- higher rates mean bigger payments on credit-card bills, home-equity lines of credit, and adjustable-rate mortgages. For these folks, it means just one more dent in a household budget that has already been dinged by higher prices for such staples as gasoline, milk, and meat. That's on top of the big increases in the costs of housing, tuition, and health insurance that have come in the past few years.

In its June 30 statement, the Fed described "underlying inflation" as "relatively low" and said it would be "measured" in implementing further rate hikes. This moderate stance pleased investors, who bid up stocks following the announcement. And the Fed has a point -- the core consumer price index was up just 1.7% in May. But that measure excludes energy and food (mainly because they are affected by factors other than economic growth), two areas where consumers' costs have gone up dramatically in the past few months.

And the sharp increase in the price of a gallon of milk or gasoline doesn't go unnoticed by most families. "The reality is the average person is feeling [the effect of higher prices] and feeling it hard," says Joel Naroff, president of Naroff Economic Consulting.


  Many companies are just now passing along higher commodity prices to consumers. In a June 30 conference call forecasting fiscal 2005 results, General Mills (GIS ) CEO Steve Sanger said increased costs for ingredients like dairy, meat, and soybeans would add an additional $165 million in expenses in fiscal 2005, after adding $110 million in fiscal 2004. General Mills announced price increases of 2% to 9% on June 22.

Although the job market has improved, tepid wage growth isn't prettying up the picture for the pinched American consumer. Average hourly wages stayed just ahead of inflation from 2001-03. But through May, real wages (adjusted for inflation) have been declining at a 2% rate, says Dean Baker, co-director of the Center for Economic & Policy Research in Washington, D.C. He worries about the consumer's health. "People are deeply in debt, and the national savings rate is extremely low," he says.

The rate hike comes amid strong consumer spending and a spike in confidence. On June 29, the Conference Board's measure of consumer confidence jumped 9.5%, to 101.9, its highest reading in two years. Also that day the Commerce Dept. reported that in May, consumer spending rose by 1% over April -- a sharp increase for one month.

However, consumer spending, which makes up 70% of the gross domestic product, might not be as healthy as it seems. The recent Commerce report revised down the pace of spending in earlier months. Kelly says that caused him to lower his estimate for second-quarter economic growth. "Consumers are finally getting squeezed," he notes.


  On June 29, Wal-Mart (WMT ) reported weekly sales that were flat with last year. Target (TGT ) also warned of weaker-than-expected June sales, and the International Council of Shopping Centers cut its June forecast on June 29. Plus, General Motors (GM ) said on June 28 that its sales for the month were below expections.

Such initial signs of weakness may prove temporary -- a "June swoon," as John Lonski, Moody's Investors Service economist described it in a June 29 research note. Most economists expect the job market to continue improving, the unemployment rate to gradually fall, and wages to perk up (see BW Online, 6/30/04, "June Looks Joyful for Jobs"). Wage increases often lag in a reovery, points out Naroff, who says he isn't worried about the health of American consumers.

Kelly, too, believes the current squeeze may pass. Consumer spending has been stimulated for the past year by tax cuts and refinancing activity. "Right now consumers are in the hungry season," he says. Tax cuts and refinancing are over and "they are waiting for the harvest of higher wages."


  Ultimately, the Fed rate hike should act to put the brakes on inflation, says John Derrick, fixed-income portfolio manager at U.S. Global Investors. "Consumers may feel a little bit of pain right now" from higher rates, he says. "But hopefully that will be offset by the benefits of inflation being brought under control."

That's certainly the Fed's aim in raising rates. The weeks and months to come will show if already squeezed American consumers will, given the pinch of higher rates, keep doing their part for the economy.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

Edited by Patricia O'Connell

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