Increased Uncertainty on Policy, Rates Will Shape the Economic Outlook in 2017 and Beyond

Overall, the economy continued to improve in the last quarter of 2016, with continued gains in the labor market and improvements in household finances. These improvements are supporting credit unions’ increased loan volume, as we saw in the third quarter Call Report data released in December.

Now that 2017 has begun, it promises to bring a lot of policy changes and increased uncertainty. Because of that, it’s a good time to take stock of how the economy is doing and consider some of the possibilities that could potentially affect the economic outlook in the near term.

Labor Markets Continue to Improve

Let’s start by looking at what’s been happening most recently in the labor markets. In the fourth quarter of 2016, job gains averaged 165,000 per month. That’s down from a little over 200,000 in the third quarter, but it’s still a solid number. It’s also a key indicator that the economy is in good shape.

Taking a slightly longer look back, employment has been rising steadily for more than six years. Despite solid job gains, there are still many job vacancies. In fact, job openings are near an all-time high. In the first 10 months of 2016, there were an average of 5.6 million jobs available each month. That’s a big improvement over the past five years. The increased demand for workers has pushed unemployment down to a level that many believe is consistent with full employment.

But, there’s still some room for improvement in labor markets. The broadest measure of labor market slack, what the Bureau of Labor Statistics calls the U-6 rate, is still about a percentage point above its pre-recession level. That measure includes unemployed workers, workers who are underemployed or individuals who have dropped out of the labor force because they don’t think they can find a job. One of the main reasons the U-6 measure remains elevated is that we still have a relatively outsized number of people who want full-time work, but who can only find part-time work.

Further, we know that labor market conditions are not uniform across the country and that people’s perceptions of whether employment conditions have improved depends on where they live. While there are states and regions where employment is still lagging, in most areas employment and job prospects for credit union members are better now than at any time in the past decade.

Household Spending and Finances Remain Strong

Strong labor market conditions also are boosting consumer incomes and confidence, which means households are spending and borrowing more.

Let us start with autos—a big-ticket item that accounts for about a third of the credit union system’s loan portfolio. New motor vehicle purchases have risen steadily since the recession ended in 2009 and in 2016 reached a new all-time high of 17.5 million units. That’s up from 12.8 million five years ago and well above the 16.5 million vehicles sold in 2006.

Home sales have also been rising. Through November, sales of new and existing homes averaged 6 million at an annual rate—up sharply from 4.6 million in 2011, when the economy was just starting to emerge from the housing bust. The current sales pace is still far below the inflated levels reached a decade ago, but it is close to the level averaged in the early 2000s, before the housing bubble formed.

With demand for housing on the rise, house prices in many parts of the country have recovered from the depressed levels recorded following the housing bust. In fact, in many states house prices are now higher than in early 2007, when house prices peaked nationally. In 15 states and the District of Columbia, house prices are at least 10 percent higher than at the housing boom peak. However, house prices in some states, like Nevada and Arizona, still have a long way to go to recover fully.

The rise in home values, along with the strong performance of equity markets in recent years, has boosted the value of household assets more than 50 percent from its low point in the Great Recession. While assets have grown, households’ debt-to-income ratio has fallen. In the third quarter of 2016, household debt as a share of disposable income was roughly 8 percentage points lower than five years ago and 27 percentage points lower than a decade ago. As a share of income, households’ monthly financial payments are near a record low.

Outlook for 2017

So, what’s the outlook for the near term?

The consensus of most analysts is that the economy will continue to perform well in the near term. Economic growth is expected to pick up a little, and growth in payrolls is projected to push the unemployment rate a bit lower. Lower unemployment is expected to push wages higher, and inflation is expected to move higher. As a result, interest rates, both on the short end of the yield curve and longer-term rates, are expected to increase. The consensus is that the yield curve—the spread between long rates and short rates—will narrow somewhat.

However, the consensus of most analysts is also that they’re less certain about their forecasts for 2017 and 2018 than usual. That’s because with a new president and Congress, it looks like the policy landscape could change significantly in 2017, and the effects of those policy changes could influence the economy’s performance well into the foreseeable future. While specific proposals have not yet been made, reports suggest that the new administration and Congress could focus on a range of important economic issues, like foreign trade agreements, immigration policy, tax cuts, infrastructure spending and regulation.

As we think about the economy in the near term, it’s good to remember that potential policy changes in some of these areas, like new foreign trade agreements and changes in existing regulations, could take time to implement, and it will take time for their effects to be felt. While these policy changes probably would not affect the economy in 2017 or maybe even 2018, they have implications for growth, employment and interest rates over the medium to long term.

Other potential changes, like tax cuts or tax reform, could be implemented quickly and have near-term economic effects. Analysts note that a tax cut put in place early in 2017 could begin to stimulate a faster pace of economic growth and job creation later in the year. Some spending policies, like infrastructure spending, could be passed quickly, but their effects would be felt more gradually.

Despite many possibilities, analysts seem to agree that, over the next year or so, some sort of fiscal stimulus, either in the form of tax cuts, increased spending or both seems likely.

What would this mean for the economy in the near term? Well, a fiscal stimulus typically raises demand and spending initially, though analysts note that it also raises the federal deficit and increases the federal debt, which may have longerterm economic consequences. Still, the initial effects of the stimulus would be to increase payroll job growth and potentially help decrease the number of part-timers who want full-time work.

Still, with the economy already near full employment, a stimulus may mean inflation, and interest rates could rise by more than the consensus predicts. How fast and by how much interest rates would rise at least partly depends on monetary policy.

A year after their previous rate increase, Federal Reserve policymakers in December voted to raise the federal funds rate target range by 25 basis points to a range of 50 to 75 basis points. According to the Federal Open Market Committee’s most recent statement, its decision to boost short-term interest rates reflected the pickup in growth over the second half of 2016 and further tightening in the labor market. Policymakers also noted that inflation has increased in 2016, though it’s still below the Fed’s 2-percent target.

In addition, Fed policymakers noted that they expect inflation to move higher as economic growth picks up slightly and unemployment declines further in 2017. With rising inflation and full employment, they are anticipating that higher short-term interest rates will be appropriate over the coming year. Policymakers also think short-term rates will increase another 80 basis points by the end of 2017 and rise an additional 70 basis points by the end of 2018.

As in previous forecasts, the Federal Reserve emphasizes that its decisions are data driven and that it will revise its views on the appropriate level of short-term interest rates as new data about the economy comes in.

Let’s consider what would happen if the economy grows faster and inflation picks up more than the Federal Reserve currently predicts. That might happen if, for example, tax cuts and infrastructure spending push economic growth and employment higher in 2017 and 2018.

If the economy is growing faster, unemployment is falling and inflation is rising more than the Fed expects, short-term interest rates could rise faster and by more than it’s forecasting. Because credit union deposit rates are likely to reflect short-term economy-wide rates, we could start to see some upward pressure on credit union interest costs.

Now that’s not the whole story on interest rates. The Federal Reserve doesn’t directly control long-term interest rates. Even if analysts have a good idea of what is likely to happen to short-term rates, the outlook for longer-term rates is much more uncertain. In general, analysts believe that long-term interest rates are affected by current short-term rates, but are also affected by expected long-term inflation and economic growth prospects. So, the conventional story is that higher short-term rates could put some upward pressure on longer-term rates.

But, again, that’s not the whole story. If rising short-term rates mean that the economy is more likely to slow in the longer term and inflation will fall, long-term rates could fall at the same time short-term rates are rising. We’ve recently seen that short- and long-term rates can move differently for a time.

For example, just after the election, the interest rate on the 10-year Treasury note rose about 60 basis points, even though short-term rates had not yet changed. And, since the Federal Reserve raised short-term rates, long-term rates have declined slightly.

Turning back to the consensus forecast, most analysts think that long-term rates will continue to rise over the next few years. They expect the 10-year Treasury note rate to rise to 2.8 percent by the end of 2017 and to rise by an additional 40 basis points by the end of 2018.

Conclusion

In summary, the economy headed into the new year in a solid position. The current consensus outlook for 2017 is mostly a continuation of 2016’s trends. For credit unions, the outlook for fundamentals like employment and consumer demand should help to support heathy credit union financial performance in 2017.

However, there is a lot of uncertainty about future economic policies and how they will influence the economy going forward, especially in the second half of 2017 and into 2018. This uncertainty could linger for several months or more, until specific policy proposals have been put into action.

In addition, the Federal Reserve has signaled that short-term interest rates are poised to rise further. Private forecasters think longer-term interest rates will be heading higher, too. The outlook for interest rates—specifically for longer-term rates and the shape of the yield curve—is more uncertain. That uncertainty may be reflected through increased volatility in long-term interest rates during the first part of the year.

That means the outlook for credit union net interest margins is also more uncertain. Because of this, now is an especially good time for your credit union to re-evaluate what its income and balance sheets might look like under a range of interest rate scenarios, including scenarios in which short-term rates rise relative to long-term rates and long-term rates rise relative to short-term rates.

As always, we’ll continue to monitor the economy, policy environment and forecasts and keep you up to speed. You can read our regular column here in The NCUA Report, or watch our updates in future episodes of our Economic Update video series. In the meantime, visit NCUA’s website and check out the Quarterly U.S. Map Review for the third quarter. It includes maps of key credit union indicators by state and tables with economic information. It is available online at http://go.usa.gov/x9YDQ.