FED´S PLANS HANG IN HOUSEHOLD BALANCE SHEETS / THE WALL STREET JOURNAL

Heard on the Street

Fed's Plans Hang in Household Balance Sheets

By Justin Lahart

June 16, 2014 3:58 p.m. ET



If the Federal Reserve tightens policy too soon, it may risk putting the squeeze on U.S. consumers.

Fed policy makers meet Tuesday and Wednesday, and with the economy shrugging off the winter's tough weather, the world looks a little different from when they last gathered. There have been two consecutive jobs reports showing an unemployment rate of 6.3%, compared with the 6.7% seen at the Fed's April meeting. Inflation readings, while still low, have picked up. Measures of financial conditions, ranging from credit spreads to stock-options prices, have gotten easier.

Taken alone, those would argue for policy makers stepping up their timetable for raising the target for overnight rates, perhaps sooner than in mid-2015 as markets expect. But U.S. households' balance sheets are still in a precarious enough state that, absent a good deal of improvement in their income outlook, raising rates could stifle spending more than the Fed is prepared for.

To judge by how much their debts are cutting into their paychecks, Americans' finances are in fine condition. The household debt-service ratio—interest and debt payments as a percentage of after-tax income—fell to 10% last year from a 2007 peak of 13.2%, putting it at its lowest level since the Fed began tracking it in 1980.

To some extent, that reflects progress people have made toward working off their debt (sometimes through walking away from it) since the financial crisis. Indeed, the level of household debt to income, at 103% in the first quarter, was down substantially from its 2007 peak of 130%.

But that only brings it back to where it was at the end of 2002—a level that, with the debt people took on to keep spending through the 2001 recession, seemed high at the time. So much of the drop in the debt-service ratio is a function not of lower debt levels, but lower interest rates. There has been a massive amount of mortgage refinancing activity over the past five years as households took advantage of lower mortgage rates. Rates on new auto loans are at their lowest levels on record, as are credit-card rates.

Moreover, there may be less to the reduction in debt levels relative to income than is readily apparent. That is because much of the increase in overall household income over the past several years has accrued to people at the top rungs of the income ladder. Among the bottom 90%, the debt-to-income picture may not have improved much, if at all.

With debt levels still high, rate increases could pack more punch. Homeowners with low mortgage rates locked in would think twice about moving, while first-time home buyers would have higher payments. Affording that new car would get more onerous. And carrying a credit-card balance would cut more deeply. With the increased interest income some people would receive providing only a partial offset, spending (which has been posting steady, but not stellar, growth) would adjust lower.

The way out is for wage growth to increase to the point it can support spending through higher interest rates.

Until then, the Fed may opt to hang loose.