KALAMAZOO — The U.S. Senate is supposed to vote on a bill by the middle of next week that, if approved, could add a 27.5 percent tariff to all goods made in China that are sold here. The import tax is being promoted as a way to force the Chinese government to stop undervaluing its currency, a move that many U.S. manufacturing firms favor.
A tax on Chinese goods would mean higher prices for American consumers as products sold at Wal-Mart and other discounters would have to rise. But what does such a levy and a corresponding adjustment to China’s yuan signify for the lending market?
“Most economists do not like tariffs because these do cause prices to go up,” said George Erickcek, senior regional analyst with the W.E. Upjohn Institute for Employment Research.
Higher consumer prices can fuel inflation, a scenario made even more likely when energy costs are rising. And growing inflation often leads to higher interest rates for consumer and commercial loans, as boosting rates has traditionally been seen as a way to fight inflation.
Higher rates for loans may cause businesses to put off building projects and consumers to delay buying or building a new home. Both could cripple the construction industry. Holders of variable-rate mortgages would see their monthly payments go up, which could lead to foreclosures and bankruptcies — two things that lenders don’t want.
To prevent these from happening, the Federal Reserve has been trying to rein in inflation by steadily bumping the short-term rate. But despite the nine recent hikes the Fed has made to that rate, rates on long-term loans, like mortgages, haven’t risen in tandem. Why?
“One of the explanations is because inflationary expectations have stayed relatively low. In spite of gas prices being very high, investors seems to be saying that they expect inflation to remain quiet,” said Erickcek.
“But if the tariffs are put on and this causes a general increase in prices, then this may cause long-term rates to increase. And many households that are using some of the more creative mortgage financing options, like interest-only mortgages or flexible mortgages, could find themselves in a bind,” he added.
Although flat long-term rates have been good for the mortgage market and construction industry, the combination of rising short-term rates and stable long-term rates hasn’t been a good omen for the overall economy in the past.
“It’s worrisome. When you see the spread between long-term rates and short-term rates shrinking as we see now, historically that has lead to a slowdown in the economy,” said Erickcek.
In fact, history shows that when the two rates get closer to each other than 2.5 percent, the economy is more likely to go into a downturn. And when payments on shorter Treasury notes are higher than those on longer Treasury bills, the economy often goes into recession.
A recent payout on a 90-day Treasury note was within 1 percent of the payout on a 10-year Treasury bill. A year ago, that spread was nearly 3.3 percent. During the last recession, which started in 2000, short-term payouts exceeded those of longer-term rates that year. (See related chart.)
The Gross Domestic Product numbers for the first quarter, though, show the economy is in good shape, despite the declining cushion between the interest rates. That may mean inflationary expectations are low for now, so the closeness of the two doesn’t have as dramatic of an effect that it had five years ago. So with low inflation and good economic figures, what else could be happening?
“There might be a third factor going on and that could be that there is simply a lot of money being invested in the U.S., and that is keeping long-term rates down. We do know that there is a lot of foreign investment from China and other countries. They seem to be investing more in long-term government securities than usual and maybe it’s the foreign investors that are keeping long-term rates down,” said Erickcek.
China reportedly bought $200 billion worth of this nation’s debt last year and was a top-five foreign investor in government securities in 2004. A report in the New York Times said China was on track to buy $300 billion this year. But if Congress taxes the yuan, China might seek revenge by not purchasing this country’s record-level debt.
“If they stop buying our securities, interest rates will go up. The government would then have to entice other buyers to buy our debt by raising interest rates,” said Erickcek.
The Senate has said it would vote on the tariff bill, S295, by July 27. Both of Michigan’s senators, Democrats Carl Levin and Debbie Stabenow, are sponsors of the legislation.
“China is clearly keeping the value of its currency below market value in an effort to support its export base. I agree with the authors of the bill that it is unfortunate that China is doing this,” said Erickcek.
But a tariff could raise concerns about inflation and force the Fed to hike short-term rates even higher. And to keep the economy out of recession, long-term interest rates would likely have to go up to maintain the spread — and that action could have dreadful consequences for lenders, borrowers and builders.
“I think, though, that their solution will probably cause more harm than help,” Erickcek said of the Senate bill. “Because we import so much, I think the tariff is going to cause prices to increase and those inflationary expectations would then likely spill over into the mortgage market.”
**Most economists believe that the interest the government pays on the 10-year Treasury bill should be at least 2.5 percent higher than the rate it pays on the 90-day Treasury note for a healthy U.S. economy and attractive lending rates.
Economists also believe that a recession is on the horizon whenever the short-term rate comes precariously close to, or tops, the payout on the long-term security.
Over the last year, from June 30, 2004, to June 30, 2005, the difference between those rates has fallen from what economists might term a “healthy spread” to a payout similar to the one in 2000 when the economy went into recession. At the end of last month, the distance was less than 1 percent. A year earlier, it was a healthier 3.29 percent
The following chart lists the interest rates paid on the 90-day T-notes and 10-year T-bills and the spread between the two rates for the last five years. Note that in December 2000, the short-term rate was higher than the long-term rate.