Interest rates, where they are going and how they affect the economy, are critical factors in the financial health of credit unions and their members. For nearly a decade, interest rates have been at or near historic lows as the economy recovered from the Great Recession. Now that the unemployment rate has fallen, by most economists’ views, to full-employment levels, interest rates have turned up. With the interest rate environment changing, it’s a good time to review interest rate fundamentals and the channels through which they can affect credit unions.
Interest Rates: The Very Basics
An interest rate is just a price paid for borrowing money, usually quoted as an annual rate. With more opportunities for borrowers to default over longer time spans, lenders generally charge a higher price for long-term loans. As a result, long-term interest rates are usually higher than short-term interest rates.
In the U.S., market news and discussions about interest rates center on U.S. Treasury rates, which practically have no credit risk. That’s an important consideration for tracking how economic fundamentals affect interest rates because borrowers with different credit risk profiles will be charged different interest rates.
The chart above shows how rates on Treasury securities with three different maturities have changed over time. Notably, interest rates were generally low in the 1950s and 1960s, but exploded in the 1970s and early 1980s when inflation in the U.S. zoomed to double-digits, reaching almost 15 percent over the year ending in March 1980. After the early 1980s, rates began a long, slow decline that lasted through the late 1990s and early 2000s. Rates then collapsed, especially on the short end, following the bursting of the housing bubble and the onset of the Great Recession in 2007.
What forces move interest rates up and down? There are three principal factors: fluctuations in economic activity (like GDP growth and jobs), fluctuations in inflation, and changes in the likelihood of financial market disruptions. For short-term rates, what matters most is what is likely to happen to these factors in the very near term. Long-term rates are much more sensitive to how these factors are expected to change over the long term.
Short-Term Interest Rates
Let’s examine short-term rates a little more closely. Financial market discussions often make it seem like the Federal Reserve determines short-term interest rates. But, in reality, Federal Reserve policies both effect and are affected by what’s going on in the economy.
Knowing how economic fundamentals are changing is helpful to understanding changes in interest rates. A weak economy with low or falling inflation likely means the Federal Reserve will reduce interest rates to try to stave off a recession, or at least cushion the fall. An economy at near full employment with stable or rising inflation means the Federal Reserve will likely lift short-term interest rates to head off the potential for higher inflation that could hurt the economy in the long run. And, if the economy is in the throes of a financial market disruption—like it was in 2008—short-term interest rates are likely to sink quickly, as the Federal Reserve supplies liquidity to keep the economy afloat. Currently, the Federal Reserve’s main policy rate is the federal funds rate or the rate that banks charge each other for overnight borrowing. It influences that rate by providing more or less liquidity to banks, which affects the interest rate at which banks lend to each other. Because the Federal Reserve works through banks, its control of the funds rate isn’t exact. As a result, the Fed usually sets a range of 25 basis points for the federal funds rate target. The current range, set in mid-March, is 1.50 to 1.75 percent, up from 0.75 to 1.00 percent in March 2017.
Chart 2, located above, shows that when the federal funds rate target changes other short-term rates usually follow suit quickly, including the bank prime rate—the rate typically charged to the bank’s best commercial customers and often used to price other loans. Credit union rates on shares, certificates, and other deposits are influenced heavily by changes in short-term interest rates.
Chart 3 shows that rates on share certificates and money market accounts tend to move with the 3-month Treasury rate, while interest rates on share drafts and regular shares show much less movement. Recent data suggest that roughly 50 percent of credit union shares and deposits are in accounts that show significant sensitivity to short-term market interest rates. That means if short-term interest rates are rising, so are credit union interest costs.
Long-Term Interest Rates
Changes in long-term interest rates are affected more by changes in the long-term outlook for economic activity, inflation, and the likelihood of a financial market disruption. That means a near-term change in a fundamental economic factor can affect short-term and long-term rates differently. For example, suppose the economy were at full employment and inflation jumped. Short-term interest rates would likely head higher. At the same time, the increase in inflation might convince some market participants that higher short-term rates will eventually slow the economy, or maybe even cause a recession. That concern about economic activity in the longer term might actually cause long-term interest rates to remain unchanged, or fall slightly, even as short-term rates rise.
Other Factors Influence the Longer-Term Rate Outlook
Current and expected federal deficits can play a role in determining long-term interest rates. When the economy is strong, the demand for credit is usually strong. An increasing federal deficit adds to the demand for credit and, to get savers to lend additional funds, interest rates need to go up. However, if the economy is in a slump, an increase in the federal deficit may have little or no effect on interest rates at all. Savers may be willing to lend to the government even at a low interest rate, especially since it has no credit risk for the most part.
In unusual circumstances, the Federal Reserve can also directly influence long-term rates by buying longer-term Treasury securities and guaranteed, mortgage-backed securities for its own portfolio. The Federal Reserve’s quantitative easing policy that began in 2010 lowered long-term interest rates noticeably as part of an attempt to stimulate the economy when short-term rates were essentially at zero. Now the Federal Reserve is beginning to unwind its long positions. Many analysts think this will put noticeable upward pressure on long-term rates over the next couple of years.
Other factors affect long rates more than short rates. For example, investors in other countries consider how the U.S. economy is expected to perform relative to their other potential investment options. If long-term U.S. performance is expected to be relatively better than the investor’s own country, then money is likely to flow to the U.S. That inflow affects the U.S. economy in several ways, including through exchange rates. But, generally, greater foreign inflows lead to lower long-term U.S. interest rates.
Additionally, concerns about rising geopolitical tensions often have a similar effect. U.S. Treasury securities are considered to be among the safest in the world, so rising tensions across the globe often are associated with a “safe haven effect” that generally drives down U.S. interest rates, with much of the effect concentrated in the longer term.
In the U.S., the bellwether long-term interest rate is the rate on the 10-year Treasury note, though the Treasury also issues 20-year and 30-year securities. Changes in the 10-year Treasury rate typically filter through quickly to other longer-term loans, like mortgages, which are often priced directly off the 10- year Treasury.
The Net Result: The Yield Curve
The net result of all of the factors that affect short-and long-term interest rates can be summarized in the yield curve, which is simply a chart that plots interest rates from the short term to the long term for a specified point in time. Changes in the underlying factors cause short-term and long-term interest rates to change, which, depending on the factors, can cause the yield curve to move higher (all rates rising together), fall (all rates falling together), steepen (long-term rates rise relative to short rates), or flatten (short rates rise relative to long rates).
Credit unions, like other depository institutions, engage in maturity transformation. They take in deposits on which they pay short-term interest rates and lend money in the form of longer-term loans at long-term rates. A credit union’s net income largely reflects the difference in their short-term deposit rates and their long-term lending rates, including the long-term rates they currently charge and the rates they charged on previously made loans.
The interest rates a credit union can pay on deposits or charge on loans are influenced heavily by economy-wide, short-term and long-term rates. The difference between economy-wide, long-term rates and short-term rates is a key indicator of the pressures on credit union net income. Prudent credit union managers should understand how their income statements and balance sheets could change under a variety of interest rate scenarios, including flatter and steeper yield curves, and consider the risks and opportunities they pose to their credit union’s financial performance.