At the Crossroads: Banks See Interest Rates Rise as Economy Shows Signs of Improvement
Economic Growth in the Current Expansion Has Been Unbalanced
Since the end of the recession in November 2001, the U.S. economy has expanded at a subpar pace. Real gross domestic product (GDP) expanded by nearly 3 percent during 2002 and at an annualized rate of roughly 2 percent through June 2003. Thus far, this pace has been insufficient to generate net employment gains. While the 2001 inventory correction and accompanying cyclical slump are well behind us, certain longer-term, secular features (such as strong labor productivity growth) are combining with slack global demand and global pricing pressures to limit the strength and breadth of the ensuing economic expansion.
Household demand has been the major source of real GDP growth since the end of the recession. Consumer spending accounted for 2 percentage points of the overall 2.5 percent average annualized gain in real GDP between December 2001 and June 2003. Over the same period, the net contribution of all other sectors was only 0.5 percentage points of real GDP growth. The contributions from government spending, new residential investment, and inventory accumulation were nearly offset by expansion of the trade deficit and a modest net contraction in business investment for plant, equipment, and software, as illustrated in Chart 1.
The drag on growth from net exports is in part a long-term structural issue but also may reflect unusually slow worldwide economic growth. Weak foreign demand has limited any improvement that might otherwise have resulted from the 7 percent drop in the trade-weighted value of the U.S. dollar since December 2001. Real imports rose by about 10 percent in 2002, while real exports grew by roughly 4 percent. During the first half of 2003, real imports continued to inch ahead, while real exports fell by about 1 percent. Since real export growth appears unlikely to accelerate over the near term, it will be critical that domestic spending on capital equipment and inventories gains traction in order to provide a more well-rounded, stronger expansionone that is less likely than the present one to be derailed by any unforeseen shocks. A stronger business contribution is especially necessary given the recent high degree of dependence on the consumer. Household spending for goods and services grew throughout the recession for the first time on record, while the dip in new residential investment was extremely mild. Consequently, pent-up demand from the household sector, which traditionally boosts demand and production growth immediately after a recession, may not provide as much momentum in this expansion.
While the consumer sector has carried growth in recent quarters, the opposite is true of business spending and investment. The reluctance of businesses to hire additional employees and invest in new equipment has been a significant drag on the economy's progress since the recession ended. Some have attributed this reluctance to sluggish sales growth; however, while not robust, sales for all U.S. nonfinancial corporate businesses grew at a 4 percent annualized pace in both fourth quarter 2002 and first quarter 2003. By way of comparison, sales for these firms grew at an average annual pace of about 6 percent between 1995 and the beginning of the recession in early 2001.
Other explanations include excess worldwide production capacity in many sectors,
such as motor vehicles and parts, commercial aerospace, telecommunications,
textiles, chemicals, and agricultural commodities, as well as increasing
globalization of economic activityboth of which have impinged on
pricing power in certain domestic industries that either sell internationally
or produce goods and services exposed to import competition. While it
is not readily apparent to what extent nonfinancial corporate business
sales gains have been constrained by price discounting, the trend in the
unit price of real nonfinancial corporate GDP may offer some insight into
the weak state of business pricing power in the current environment (see
In addition to global supply and pricing pressures, strong and enduring labor productivity gains resulting from the late 1990s surge in business investment may be limiting the need for additional business investment and hiring in the near term. Finally, it has been suggested that some U.S. firms may have been more focused recently on balance sheet restructuring, corporate governance and control issues, accounting and financial reporting accuracy, and the correction of other imbalances from the 1990s than on expanding their markets and operations. Over the next year, most of these distractions should fade, although weak global demand could continue to weigh on growth until other major economies begin to grow at rates approaching their potential.
The Jobless Expansion Is Weighing on Economic Growth
To an even greater extent than was the case after the 1990-91 recession, the period since November 2001 can be called a "jobless recovery." Weak job growth in the wake of the last two recessions may reflect that they were short and mild compared with previous recessions, which were typically "V-shaped" and had a more pronounced upturn of employment soon after the recessions' ends. Even so, against the benchmark provided by the early 1990s jobless recovery, the recent trend in U.S. payroll employment may be cause for some concern. As Chart 3 shows, nonfarm payrolls in July 2003 were 2 percent lower than in early 2001. By way of comparison, 1.5 years after the peak preceding the early 1990s recession, nonfarm payrolls were already well on their way to recovery and were less than 1 percent below the prior high.
Why has this divergence occurred? An obvious answer is the manufacturing sector's reluctance to hire additional workers. The world continues to experience subpar economic growth, replete with excess capacity and disinflationary, or outright deflationary, pressures. These pressures are likely limiting firms' collective pricing power, especially in manufacturing. As would be expected, firms operating in an environment where the price of their product is declining face two options to bolster earnings. The firstmaking up for a lower unit price by increasing sales volumehas proved quite difficult given the weak state of global demand in recent years. This leaves the second optioncutting costs and enhancing efficiency by bolstering productivity. Manufacturing firms are more exposed than many services firms to pricing pressure, either because their markets are global in nature or because they are subject to a high degree of import competition. In addition, labor productivity gains have been greatest in the manufacturing sector, although this may reflect in part a better ability to measure output per hour in these industries than in services.
Payroll reductions and a hesitancy to respond to any upturn in demand with new hiring are two approaches manufacturers are taking to control costs. The U.S. economy shed 2.7 million jobs on net between the February 2001 peak and July 2003, with 90 percent, or 2.4 million jobs, coming from manufacturing. Further, half the reduction in factory payrolls occurred after the end of the recession in November 2001. During that time, nonmanufacturing payrolls inched up by roughly 183,000 positions, due mostly to strength in education and health services and, to a lesser extent, local government.
Weak Job Growth Has Been Offset, So Far, by Fiscal and Monetary Policy
Proactive and sizeable fiscal and monetary stimulus helped consumer spending carry economic growth through both the recent recession and the subsequent period of moderate growth and lackluster labor market conditions. While wage and salary growth decelerated sharply through the 2001 recession and remained sluggish subsequently, overall income continued to grow at a somewhat sturdier pace. This was due in part to anti-recession income transfer programs, such as unemployment insurance.
Additionally, gains in after-tax income have generally exceeded those
for personal income since summer 2001, reflecting reduced income tax rates
enacted in 20012 (see Chart
4). In addition, the 2003 Jobs and Growth Tax Relief Reconciliation
Act is expected to boost year-ago after-tax income growth beginning in
July 2003. This stimulus will last through mid-2004, at which time, absent
further tax cuts, year-over-year income growth will return to its underlying
trend and more closely reflect changes in net employment.
Monetary policy also has been quite accommodative, contributing to lower
short-term and mortgage interest rates through mid-2003. Lower short-term
rates helped to reduce the cost of variable-rate consumer credit. They
also enabled some households to reduce their debt service burdens not
only by refinancing outstanding mortgage debt but also by rolling higher-cost
debt into lower-cost, fixed-rate, tax-favored mortgage debt. In addition,
favorable mortgage rates spurred a significant surge in cash-out refinancing
volume during the past two years.3 Momentum
from that surge will provide support to consumer liquidity through at
least the end of 2003 even though a rise in mortgage rates after mid-June
quickly began to dampen refinancing demand.
As of mid-2003, there was little evidence that businesses planned any
significant return to hiring. According to Manpower Inc.,
which conducts quarterly surveys of the hiring intentions of more than
15,000 employers in 473 cities, the outlook for near-term job gains turned
down in the first half of 2003.4Chart
5 shows the recent trend in this survey's measure of net hiring strength,
which attempts to gauge the share of businesses that plan to increase
hiring in the next three months. In addition, the chart provides the year-ago
change in U.S. nonfarm employment. The results of the third quarter 2003
Manpower survey suggest that employment probably will not expand significantly
over the remainder of the summer.
A monthly survey of hiring intentions by the National Federation
of Independent Business also showed little hiring interest
by small firms in June, while the employment sub-index from the Institute
for Supply Management's July survey of manufacturing offered
a similarly glum assessment for renewed factory sector hiring.
Business Inventories and Investment Also Are Weighing on Growth
Businesses' inventory liquidation was a significant drag on growth during the 2001 recession. However, as liquidation turned to positive accumulation in 2002, this component of business spending became a considerable boon to GDP growth (see lighter-shaded bars on Chart
6). Now that inventories are better aligned with the pace of sales, no additional stimulus from inventory accumulation is anticipated until aggregate demand growth shows a noticeable and sustained pick-up. In fact, during the first half of 2003, inventory liquidation reduced net economic growth at the margin.
Business fixed investment in equipment, software, and buildings contracted
more than usual in the recession and has been, at best, an insignificant
factor in the recovery (see Chart 6). Equipment
and software spending, which makes up about 85 percent of total business
fixed investment, has now grown in four of the last five quarters. However,
offsetting this spending have been outlays on commercial buildings, which
fell for ten consecutive quarters before rising modestly in the second
quarter of 2003. The net effect has been that business investment (the
darker-shaded bars in Chart 6) has contributed
little to overall economic growth until recently.5
In second quarter 2003, overall business spending rose and contributed nearly 1 percentage point to real GDP growth because of strength in the equipment and software segment and an increase in spending for structures after six quarters of decline. In fact, investment in structures leveled out in first-half 2003, albeit at a pace about 25 percent slower than in late 2000. Thus, it should no longer weigh heavily on overall business investment, although high vacancy rates and the potential for continued subdued employment growth likely will keep this category from contributing much to economic growth for some time.
The recent trend in equipment and software outlays has been somewhat mixed, depending on the type of investment. Spending for information processing equipment and software rose at a double-digit pace in four of the six quarters ending June 2003. Growth in this component, which accounts for about 60 percent of total investment in equipment and software, helped offset continued weakness in spending for industrial and transportation equipment.
Current capacity utilization among U.S. manufacturers is below 73 percent, which might suggest that years of production growth will be needed before the utilization rate returns to 80 percent, a rate typically supportive of a healthy pace of new investment. The amount of excess capacity varies considerably among domestic manufacturers, howeveras low as 63 percent among high-tech firms but 74 percent among other manufacturers as a group. The decline in investment spending over the past three years has contributed to slower growth in the U.S. capital stock, or its total productive capacity. This development, plus rising demand for manufacturers' output, should help ease excess capacity, thus bringing closer the time when need for new investment arises.
Along this line, manufacturers' new orders for nondefense, nonaircraft capital
goods started rising in late 2002. Production of such equipment is typically
indicative of broader investment trends, so developments through midyear
2003 suggested a potential strengthening of business investment going
forward. In addition, some firms are experiencing an upturn in orders
for defense-related goods that will spur further investment. Various national
and regional surveys of manufacturing firms reinforce the idea that conditions
are improving, and that demand for capital goods will rise in coming quarters.6
Banking Industry Continues to Thrive Despite Unbalanced Economic Growth
During first quarter 2003, net charge-offs at FDIC-insured institutions totaled
$10.4 billion, $1.2 billion (10.6 percent) below the level of first quarter
2002. This is the second quarter in a row that industry charge-offs have
been lower than a year earlier, following two-and-a-half years of rising
charge-offs. Significant declines in net charge-offs from credit cards
and commercial and industrial (C&I) loans, which dropped 18.5 percent
and 10.7 percent, respectively, drove the overall improvement.7
Noncurrent loansloans past due at least 90 days plus those on nonaccrual statusalso have improved since third quarter 2002. Aggregate noncurrent C&I loans fell by $1.3 billion (4.7 percent) during first quarter 2003, the second consecutive quarterly decline. Developments at large commercial banks with assets of $1 billion or more, the group most severely affected by troubled corporate borrowers during the recent recession, have driven the overall improvement. The group of 413 large commercial banks accounts for just 5 percent of total insured institutions but held 87 percent of C&I loans in first quarter 2003.
After reaching a peak of $1.05 trillion in fourth quarter 2000, C&I loans
outstanding at all commercial banks dropped to $907 billion by first quarter
2003. About $57 billion of the decline occurred in the year ending first
quarter 2003. Shrinking C&I portfolios reflect both lower demand,
given lackluster business investment, and generally tighter lending standards
on the part of the banks.8
Despite weak commercial real estate (CRE) fundamentals in some markets, there has been only a minimal effect on bank CRE portfolios. A repeat of the large-scale losses in commercial bank CRE portfolios in the last cycle does not appear likely. Still, the nation's commercial banks registered increases in noncurrent CRE loan portfolios of $530 million, or 7 percent, during first quarter 2003, and charge-offs are trending upward. As a share of total CRE loans at commercial banks, however, the noncurrent portion is still a low 0.95 percent. This is a moderate increase from 0.90 percent at year-end 2002 and 0.94 percent at year-end 2001.
Charged-off CRE loans have increased steadily from a low of $38 million in 1997 to $1.17 billion in 2002 but, as a percentage of CRE loans outstanding, increased from 0.01 percent in 1997 to just 0.14 percent at year-end 2002. Thus, CRE delinquencies and charge-offs as a percentage of total CRE loans remained near historic lows during the past two years.
Commercial banks and thrifts have benefited from strong consumer loan demand. This is evidenced by growth in consumer loans over the four years ending March 31, 2003, which averaged 6 percentup from an average of 3.3 percent in the prior four-year period. Even with this growth, banks and thrifts continue to report modest levels of noncurrent consumer credits. For first quarter 2003, the ratio of noncurrent consumer loans to total consumer loans was 1.35 percent. Although this average ratio was similar to the levels recorded during the two years immediately following the 1991 recession, it was below the peak of 1.50 percent seen during that recession.
The banking industry also has enhanced its profits through credit card lending activities. Institutions classified as credit card lenders reported an annualized return on assets (ROA) of 3.66 percent for first quarter 2003, the highest since first quarter 1994, when the figure was 3.81 percent. Despite the recent strength in credit card profits, annualized net charge-offs rates remained higher in first quarter 2003 than in much of the 1990s. Annualized net charge-offs to total loans for credit card lenders reached 5.57 percent in first quarter 2003, well above the 4.97 percent in first quarter 1992a year or so after the end of the prior recession. Meanwhile, noncurrent credit card loans declined in first quarter 2003 by $919 million (or 14.3 percent). The higher profit margins of credit card lenders, whose businesses are benefiting from improved credit-scoring technologies relative to the early 1990s, have helped compensate them for the higher credit risks of such unsecured lending (see Chart 7).
The total outstanding debt of U.S. households increased by $768 billion in 2002. Mortgage debt accounted for 87 percent of this amount. For FDIC-insured institutions, mortgage-related lending accounted for some 64 percent of net loan growth during 2002 and 70 percent of asset growth in first quarter 2003. During the year ending March 2003, first and junior liens outstanding at insured institutions rose 15 percent. In addition, the industry has experienced double-digit growth in home equity lines of credit. Home equity lines of credit held by insured institutions as of March 2003 totaled $277 billion, up 39 percent from a year ago.
Meanwhile, mortgage-backed securities (MBS) offered attractive investments for commercial banks and thrifts. The banking industry's holdings of MBS grew by 20 percent to nearly $1 trillion between the first quarters of 2002 and 2003, far surpassing previous year-ago growth in first quarter holdings. As discussed later, these assets likely declined in value late in second quarter 2003, as mortgage interest rates climbed dramatically.
Despite a rising concentration in mortgage-related assets, mortgage debt historically has shown lower levels of credit exposure than other loan types. In addition, low interest rates have kept the household debt service burden at a reasonable 14 percent of disposable income, despite recent large increases in household indebtedness. To the extent that most of this recent debt accumulation has taken the form of fixed-rate mortgage borrowing, household debt service burdens may not rise appreciably with higher interest rates over the business cycle. Further, any sustained rise in interest rates likely would imply that the recent fiscal and monetary stimuli have been successful in spurring economic growth, so advancing employment and aggregate income would be expected to improve debt service capacity.
Commercial banks and thrifts have profited from the boom in mortgage originations. Insured institutions identified as mortgage lenders reported a record-breaking ROA of 1.49 percent in first quarter 2003; however, this trend appears to be driven by large institutions originating mortgage loans and holding MBS assets, as the median profitability in this segment, though also improved, remains within its historical range (see Chart 8). Further, to the extent that the recent peak in aggregate profitability reflects gains from the sale of MBS and other securities through the early part of this year, the recent rise in interest rates and subsequent decline in the value of securities may detract from earnings in subsequent quarters. Finally, even though net charge-offs for mortgage lenders also increased modestly, to 0.19 percent from 0.16 percent in the prior year, these low loss rates speak to the relatively low credit risk of residential mortgages.
While stronger economic growth likely will result in a continued improvement in credit quality, it also appears likely to bring higher interest rates, which will raise the cost of credit to borrowers and the cost of funds to banks and thrifts. Long-term interest rates have risen sharply in the third quarter of 2003, even as the federal funds target rate was cut an additional quarter percent to 1.0 percent in late June.
Despite the recent rise in intermediate- and longer-term interest rates, C&I loan growth may strengthen as the economy improves. Consumer loans likely will continue to grow, though possibly more slowly than in the past few years, in light of consumer debt levels and a lack of pent-up demand. Rising mortgage rates may dampen mortgage refinancing opportunities but prompt households to increase their use of home equity lines. Commercial real estate loan growth is expected to remain anemic and lag the economic rebound, given significant amounts of unused space available.
At the height of the bull market in equities, core deposits increased by only 3 percent between first quarter 1999 and first quarter 2000. Over the next three years, core deposit growth more than doubled, rising 7 percent in 2000, 8 percent in 2001, and nearly 10 percent in the year ended first quarter 2003; however, a stronger stock market in 2003, coupled with better returns in other investment opportunities, may begin to reduce the safe-harbor appeal of bank deposits. This situation, coupled with record low deposit rates, may lead to modest core deposit growth at most insured institutions going forward.
If banks choose to supplement any shortfall in core deposit growth through
borrowed funds, to the extent these funds are not priced off
short rates, funding costs will begin to increase at the margin. This
rise in funding costs may occur more rapidly than asset prices adjust
upward, especially if asset prices are tied to a short-term rate,
such as prime, which likely will remain fixed at least through early 2004.
Despite the boost and earnings brought about by the widespread refinancing of mortgage debt and record home sales in recent years, interest rate risk issues for many mortgage lenders may be elevated. Specifically, record long-term, fixed-rate mortgage origination volume during the historically low rate environment that persisted up to summer 2003 may have generated extension risk for many mortgage portfolio holders. This can result in net interest margins being squeezed as lenders hold low-yielding, long-lived, mortgage-related assets while funding costs reprice upward along with market interest rates.
Also, banks that are active mortgage loan securitizers may see declines in this form of funding as new loan originations and refinancings begin to slow down. As long-term rates increase, many banks will see their unrealized securities gains shrink and perhaps begin to experience unrealized losses, further straining liquidity. The banking industry as a whole has seen significant increases in MBS holdings over the last couple of years (see Chart 9). Banks with high proportions of MBS and intermediate and long-term agency and treasury securities will be most at risk for future unrealized losses.
Banks' Strong Performance Should Continue, Though Higher Interest Rates May Raise Some Concerns
The reluctance of businesses to hire new employees and invest in new equipment has been a significant drag on the economy's progress since the recession ended. Possible explanations include sluggish sales growth in a weak global economy and reduced pricing power due to excess global capacity, which pressures margins and result in heightened cost control efforts. Other explanations include strong and enduring labor productivity gains resulting from the late 1990s surge in business investment, which may be limiting the need for business investment and hiring in the near term. Finally, it has been suggested that some U.S. firms during the past year may have been more focused on balance sheet restructuring, corporate governance and control issues, accounting and financial reporting accuracy, and the correction of other imbalances from the 1990s than on expanding their markets and operations. Over the next year, most of these distractions should fade, although weak global demand could continue to weigh on growth until other major economies begin to grow at rates approaching their potential.
The banking industry continues to do well and credit quality continues to improve despite this climate of subpar economic growth. The recent rise in interest rates, however, may raise certain concerns for the industry, particularly for mortgage lenders. These challenges will take the form of slower growth in residential real estate loans, particularly refinance transactions; asset extension risk, which may tie up capital that could otherwise be deployed at higher interest rates; increased unrealized losses in MBS and other securities holdings; and a reduced ability to generate low-cost, core deposits, as rising interest rates spur households to seek greater yields than those offered by bank deposits.
Risk Analysis Staff
1 This metric is the difference between nominal and inflation-adjusted (real) sales (GDP) of nonfinancial corporate businesses. It is essentially the price component of business sales. 2 The after-tax income growth stimulus from the tax rebate checks issued that year appear in the graph briefly just after midyear. 3 See In Focus article in the Summer 2003 FDIC Outlook. 4 Employers declare their intentions to increase, decrease, or maintain the size of their present workforce for the upcoming three-month period. The survey was designed with the assistance of the Survey Research Center of the University of Michigan. In Chart 5, the current seasonal adjustments are by Manpower, Inc. Haver Analytics, Inc. calculated the historical seasonally adjusted series. 5 In the national income and product accounts, commercial buildings include offices, factories and warehouses, hotels and motels, and retail facilities. 6 For example, the Empire State Manufacturing
Survey by the New York Federal Reserve Bank and the national manufacturing
diffusion index from the Institute of Supply Management. 7 The 18.5 percent drop in credit card charge-offs was influenced by the sale of a large subprime credit card portfolio in first quarter 2002, which produced a spike in charge-offs at that time. 8 According to the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices, the net percentage of domestic banks reporting tightening standards for commercial and industrial (C&I) loans has been positive in every survey conducted since August 1998. See http://www.federalreserve.gov/boarddocs/SnLoanSurvey.