Will rising wages offset the impact of rising mortgage rates?
As mortgage interest rates go up, affordability declines. Only rising wages can offset the effect of rising mortgage rates. Will it be enough?
When mortgage interest rates finally begin to rise up to historic norms, a move anticipated by nearly everyone, home affordability will suffer because borrowers will need to spend more money to pay their mortgages. Since most borrowers maximize their loan amounts, the only way to overcome the problem of rising mortgage rates is for borrowers to make more money. With high unemployment and low labor participation rates, employers don’t need to increase pay to fill new jobs, and employees lack the leverage to force employers to pay more.
But what if rising interest rates across the lending spectrum causes wages to rise? Will rising interest rates finally cull unproductive businesses from the economy and allow the best and most productive workers to demand pay increases? Will rising rates actually have the opposite effect of what many believe and actually cause incomes to rise?
By Andrew Lilico Economics Last updated: August 4th, 2014
The Bank of England’s Monetary Policy Committee is to consider an interest rate rise again this week. One thing for it to bear in mind will be the very poor real wage growth over the past few years. From 2008 to 2013, though consumer prices rose by about 16 per cent, annual earnings rose by only about 7 per cent and hourly earnings by about 10 per cent. This fed political discussions about a “cost of living” crisis: the idea that the recovery has been “for the few, not the many”.
Apparently, Great Britain is facing the same issues we are. Wages are growing more slowly than expenses are increasing, so the standard of living of the middle and lower classes is declining.
And it has fuelled the idea that households are only just managing to hang on, and service their debts without mass defaulting, because very low interest rates have meant very low mortgage repayments – hence the fear that any rise might tip households over the edge.
There is a very real risk that rising interest rates will push marginal households into default. It’s one reason interest rates will probably remain low for longer than most people think.
This may happen to some extent, and, frankly, if households have not taken advantage of five years of near-zero interest rates to adjust their consumption down and repay much of their debts, there’s little more that can be done to help them.
I get the sense that most Ponzis put their Ponzi schemes on hold and weathered the storm, hoping they can restart their profligate spending with lender cash again someday. The usual purging of Ponzi schemes associated with recessions didn’t occur. Those Ponzis with significant debts on credit cards or in ARM mortgages will be purged as interest rates go up, but it will be spread out over time so lenders can more easily absorb the losses.
There’s only so long it can be considered moral for savers and renters and other prudent folk to suffer to help out the imprudent or unlucky.
Call me cynical, but I believe macro-economists focus on data and their complex models so they can ignore the moral implications of the micro-economic impact of their policies. How else can you explain the long-term immorality of diverting money from seniors on fixed income to bail out the banks over the last 6 years?
However, contrary to what one might expect, I suspect that interest rate rises may well be associated with real wage rises; the mass defaulting scenario might not come to pass, even if quite rapid rate rises eventually prove necessary. …
This is the scenario the federal reserve is counting on. It is possible that wage growth may outpace rising interest rates, allowing borrowers to pay off their debts, and allowing future home buyers to bid up prices despite higher rates; however, is this a likely scenario? Right now, there are few signs of robust wage growth; in fact, real wages are flat, and the economy continues to sputter.
A common way to think about the relationship between low real wage growth and low unemployment is that firms were willing to hire more workers because they were cheap. But a more interesting way to consider it, for our purposes, is to note that in recessions when large numbers of workers lose their jobs and large numbers of firms go bust, it is typically the least productive firms that go under and, in surviving firms, the least productive workers get fired. If a country has a high unemployment rate because such workers are fired, it will often experience a rise in average real wages as a result. That could happen without anyone receiving a pay rise at all – it’s simply a matter of the average rising because those workers at the bottom end drop out.
I haven’t seen this issue explored here in the US. Does a change in the composition of the workforce impact the reported wage figures? We’ve been creating larger number of low-paying and part-time jobs that may mask wage increases at the higher end. I can assure you wages in real estate are not going up.
In much the same way, if an economy is successful at creating jobs at the margin, thereby keeping unemployment low, the natural tendency will be for those extra (or surviving) jobs to be less well-paid than the average. This could drag down the average real wage even if no individual actually experienced a pay cut.
This process will be amplified if, at the same time, the economy is set up to prevent the liquidation of unproductive firms (eg by having very low interest rates). Firms that are only kept going by artificially low rates are likely to have lower productivity and lower productivity growth than the firms that would replace them if they went bust. Low productivity growth firms will also have low real wage growth.
The federal reserve policy of zero interest rates keeps unproductive firms in business, preserving inefficient use of resources, assuring lower economic growth.
From the above, we learn two initial things. First, if low average real wage growth is the result of more low-wage workers being hired, then individual households may not be nearly so stretched as the average figures suggest. Second, low wage growth may to some extent reflect weak productivity growth which is, in turn, a consequence of low interest rates.
We know more low-wage workers are being hired, so does that mean individual households are not as distressed as the economic data suggests?
What if interest rates were to rise rapidly? What would happen. Obviously some households will struggle to service their debts, especially the mortgage. But there may not be so many as the raw figures imply, because rising interest rates might themselves be a driver of faster real wage growth.
Higher interest rates will be associated with faster medium-term growth across the economy because firms must achieve higher gross value to service their debts – or they will go bust. A fundamentally unproductive firm cannot carry on absorbing capital and demand, simply because ultra-low interest rates allow it to until its capital is depreciated away. As higher interest rates will mean faster economic growth generally, firms will pay their now-more-productive workers more.
Rising interest rates will finally purge the unproductive and inefficient businesses from the economy. Apparently, the federal reserve believes it superior to preserve bad businesses during the recession and purge them later when the growing economy can more efficiently absorb the debris.
But a second possibility is this. Workers might have been putting up with very low wage rises precisely because very low mortgage rates meant they could live on their salaries. A rise in interest rates might force workers to demand more rapid wage rises – they won’t simply mutely accept defaulting.
Workers need bargaining power in order to demand higher wages. If a worker is unable to go into their boss’s office and say with confidence, “pay me more, or I will go somewhere else,” then wages won’t go up. When unemployment is high, workers don’t have this power because they can’t go somewhere else, and many people are ready and willing to take their place if they quit or get fired for demanding a raise.
Suppose, for example, that workers operate close to their cash flow and balance sheet constraints, and wouldn’t want to risk that by switching jobs. This means that opportunities to achieve wage increases (either by switching job or demanding a rise from one’s boss) are not taken up. Then suppose interest rates rise, raising mortgage rates. These workers might be unable to live on the salaries they have without defaulting upon debts (that fear is, after all, what underpins our whole discussion). That changes the cost-benefit-risk analysis on switching to a new higher-paid job or demanding a pay rise from the boss. The consequence might be that there are real wage increases.
I think that’s a stretch. Bosses don’t give raises based on a worker’s need as a boss is not responsible to support a worker’s entitlements. Employers give raises to keep the most productive workers on the team.
When we think about the consequences of interest rate rises in our current low real wage growth environment, we should not assume that low real wage growth is a given and consider the best interest rate policy from there. Instead, we should grasp that raising interest rates might itself trigger more rapid real wage rises.
I don’t think so. The mechanism he proposes simply doesn’t work unless the labor market tightens up significantly. With high unemployment and a low labor utilization rate here in the US, workers don’t have the leverage to demand higher wages regardless of what their needs are.
Perhaps rising interest rates will cause wages to go up and solve all our economic problems as economists hope; however, I have my doubts about this being a smooth transition, and many people in the wrong industries or working for the wrong firms will be left behind.