Outlook Looks Strong as the Fed Moves Closer to Raising Rates

When we did our previous update, the United Kingdom’s vote to leave the European Union, or Brexit, had just sent financial markets into a tailspin. U.S. Treasury rates plunged, oil prices fell, U.S. and world equity markets declined and volatility in the markets spiked.

Fortunately, the turmoil in financial markets was relatively short-lived and most financial indicators returned—at least partly, if not fully—to their pre-Brexit vote levels. As financial markets settled, the trends in U.S. economic fundamentals we’ve seen since the middle of 2014 reasserted themselves.

Despite some monthly gyrations, average employment gains remain strong and the unemployment rate is currently at a level many consider as consistent with full employment. The steady improvement in the labor market has boosted household income and it appears that wages are starting to rise. Improvements in stock prices and house prices are lifting household wealth. Consumer optimism is also relatively high. In addition, sectors of the economy that were hard-hit by the steep rise in the dollar’s value and the drop in oil prices got a bit of a respite, as the dollar declined in value and oil prices moved higher.

So, how are things looking going forward?

Most forecasters continue to anticipate moderate economic growth through the end of 2017. Job gains are expected to average nearly 170,000 per month and the unemployment rate is projected to decline to 4.5 percent. Inflation is expected to gradually rise towards the Federal Reserve’s 2-percent inflation target. Overall, this outlook is good news for credit unions. It suggests continued strong loan growth and relatively low credit risk for many parts of the country.

But, let’s take a look at what this means for interest rates going forward, starting with federal funds rate policy.

At its September meeting, the Federal Open Market Committee decided to hold short-term rates steady, opting, “…to wait for further evidence of continued progress toward [the Fed’s] objectives.” However, federal funds rate policymakers appear to be setting the stage for at least one rate increase before the end of 2016. Three of the 10 voting members of the FOMC wanted to raise the target range for the federal funds rate by 25 basis points. That’s up from one member at the June meeting. Also, the September meeting’s statement noted the case for an increase in the federal funds rate had strengthened, citing evidence of further progress in the labor market and signs that economic growth is picking up.

As in previous statements, federal funds rate policymakers indicated the timing and pace of future rate increases will depend on how the economy performs, especially what happens with employment and inflation. Right now, overall inflation is still running well below the 2-percent target, but it is starting to firm and core inflation (which doesn’t include food or energy prices because of their volatility) has picked up. The federal funds rate expects inflation to rise as the economy gets stronger and unemployment declines even further.

Based on their individual economic outlooks, most FOMC participants think it will be appropriate to raise rates over the next few years. federal funds rate policymakers are projecting about a 25 basis point increase by the end of 2016, and another 50 basis point increase in the federal funds rate target range by the end of 2017.

Yet, the FOMC members continue to scale back their projected interest rate levels. The rates they are currently projecting for the end of 2017 are about 50 basis points lower than they projected in June and 130 basis points lower than at the start of 2016. Still, even though committee members scaled back their projections for short-term rates, the outlook—given continued moderate growth and increased inflation—is for interest rates to go higher.

Now, unexpected shocks are always a possibility—think Brexit or oil embargoes. If the economy performs better than expected, then interest rates could rise by more, and more quickly, than both the federal funds rate and markets expect. If short-term rates rise and long-term rates don’t increase in tandem, that could squeeze credit union net interest margins.

Of course, it is also possible that the economy could underperform. A weak economy would keep interest rates at or near historic lows, dampening deposit and membership growth, reducing loan demand and leading to increased credit risk. Those effects could be especially pronounced in areas that are already struggling economically.

In addition, with a new administration in place early next year, changes in economic policy, especially in the areas of taxation and government spending, could play a role in determining how the economy performs in the near term.

The bottom line is that credit unions face a range of economic risks. It’s a good idea for credit unions to try and understand how they will perform under different economic scenarios— including a weak economy with low interest rates and a stronger economy with rising rates.

You can find more information on the economic outlook, including an analysis of household spending and labor market trends and their implications for credit union performance, in our latest Economic Update video, now available on NCUA’s YouTube channel at http://bit.ly/1rU7foW.