Welcome to the New Interest Rate Environment?

To say the least, there were a lot of interesting developments in the final months of 2015.

Let's start with the broader economy: During the final months of 2015, we saw continued improvement in the labor market, with the unemployment rate falling back to its level at the start of the Great Recession. Home prices continued to rise and, by at least one national measure, finally moved above the housing-boom peak. New auto sales reached new highs for the year. The economy continued to grow, though there remained some weakness in energy-related industries and the manufacturing sector.

And, to top the year off, the Federal Reserve at its December meeting raised the target range for the federal funds rate from 0 to 25 basis points to 25 to 50 basis points. Some analysts have asked, with the economy growing and inflation low, why did they do this now?

One of the reasons the economy has recovered from the Great Recession is the Federal Reserve kept short-term interest rates extraordinarily low for nearly nine years. However, over the last year or so, the Fed has repeatedly emphasized that the economy needs less stimulus as the unemployment rate fell and inflation moved higher. As a result, over time, it has been removing the extraordinary measures it took to boost the economy.

As the Federal Reserve sees it, the economy is already either at or near full employment, which many economists define as around 5 percent unemployment. So stimulating it further may only produce higher inflation. In addition, while inflation currently is still below their unofficial target of 2 percent, policymakers believe inflation is already headed higher, after being held down by the sharp drop in oil prices in the second half of 2015.

Now, it always takes some time for Fed policy to affect the broader economy. To keep inflation from moving well beyond its target in the future, the Fed is beginning to raise interest rates now.

The Fed's outlook for interest rates going forward depends on its outlook for the economy. The consensus among Federal Reserve policymakers is for continued moderate economic expansion, with the unemployment rate remaining between 4.5 and 5 percent, and inflation remaining around 2 percent.

Based on the Federal Open Market Committee's forecasts, the median short-term rate rises to about 140 basis points at the end of 2016, to about 240 basis points at the end of 2017 and to around 340 basis points in the longer term. Roughly speaking, that's an increase of about 100 basis points for short-term interest rates each year for the next three years.

Fed policymakers emphasize that the pace of future increases in rates depends on how the economy is performing. That means, if we see faster growth, more rapid declines in the unemployment rate and a rising inflation rate, we'll also see faster and larger rate increases than the current consensus outlook. On the other hand, a slowing economy, a rising unemployment rate or falling inflation would likely mean no further rate increase or even a rollback of the recent increase.

Because there is a lot of uncertainty about the economic outlook, there is still a lot of uncertainty about the future path for short-term rates. And, even more uncertainty about how potential changes in short-term rates will affect longer-term rates.

What does this mean for credit unions? Let's take a look at the chart on the right.

It shows that, historically, some credit union interest rates have followed the economy-wide, short-term rate very closely. For example, share certificate rates and money market rates seem to follow the ups and downs of economy-wide rates. Rates on regular shares don't seem to follow the ups and downs, but they do capture the general trend of falling rates over the period illustrated in the chart.

As you can see—just eyeballing the historical relationships and considering the Federal Reserve's projection for about a 300 basis point rise going forward—there's significant potential for upward pressure on credit union deposit rates and interest expenses under this scenario.

Now, what actually happens to credit union net interest income and balance sheets will depend not only on short-term rates, but also on economy-wide, long-term rates, as well as a host of other factors. The key takeaway from the fourth quarter's economic developments is that it's likely we've entered a new interest rate environment, where rising rates— both short and long—are more the norm.

In sum, the Federal Reserve took the first step in the long-anticipated change in the interest rate environment. The strength in the economy that allowed the Fed to lift rates is good news for credit unions. Members have jobs, which brings in deposits, they want to borrow and repayment prospects are good. But, the potential change in the interest rate environment can pose challenges to many credit unions if they have not prepared for the possibility of rising deposit rates combined with an uncertain outlook for lending rates.

No matter what you think about the outlook for the economy or rates, now is a good time to evaluate income and balance sheet changes across a range of potential interest rate scenarios, including one that looks like the Federal Reserve's projection.

For more information on the economic outlook for 2016, watch the latest episode of our Economic Update Video Series on NCUA's YouTube Channel at http://bit.ly/1rU7foW.

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