In January, the Federal Reserve announced that projected economic conditions would warrant exceptionally low short-term interest rates “at least through late 2014.”
The Fed’s current policy of targeting the federal-funds interest rate in the range of 0% to 0.25% began in December 2008, more than three years ago. Credit unions, therefore, could be facing three more years—for a total of six years—of record low interest rates and all the ramifications that implies.
The Fed might raise short-term interest rates before late 2014 if credit demand by households and firms surprises us on the upside, the unemployment rate falls faster than forecasted, and the bond market’s inflation expectations jump above their current range of 1.5% to 2%.
In an unprecedented move, in January the Fed published interest-rate forecasts of individual members of the Federal Open Market Committee. This new communication strategy is an attempt to provide more transparency regarding the Fed’s goals, strategies, and tools.
Greater transparency should reduce financial uncertainty on both Wall Street and Main Street, which could then encourage faster economic growth. The Fed projects the economy will expand between 2.2% to 2.7% in 2012, and roughly 2.8% to 3.2% in 2013.
The Fed also announced an explicit long-term inflation goal of 2%, as measured by the annual change in the personal consumption expenditure price index. This action isn’t unprecedented, as many other central banks around the world have been doing it for years. This should help anchor bond market inflation expectations.
The implication of stable and low inflation expectations by financial market participants today could be lower long-term interest rates. One week after the Fed’s explicit announcement of its inflation goal, the yield on the 10-year U.S. Treasury bond fell from 2.01% to 1.85%.
What does all this mean for credit unions? Don’t expect short-term interest rates to increase until late 2014, due to an economy operating below potential for the next several years. This will maintain downward pressure on credit union asset yields and funding costs until all loans and deposits are repriced or refinanced to today’s lower interest rates.
Credit union net interest margins (yield on assets minus cost of funds) are expected to decline from 3.18% in 2011 to 3.1% in 2012, as asset yields fall faster than funding costs. This 8 basis point (bp) drop in net interest margin is expected to be offset by a 10 bp drop in provisions for loan losses (as a percentage of assets), resulting in a slight boost to the credit union bottom line.
It looks like credit union 2011 return on assets (ROA) numbers will be about 0.7%. For 2012, CUNA’s economists are forecasting a slightly better year with ROA increasing to 0.85%.
If the Fed’s actions can stimulate additional economic growth and lower the unemployment rate, this will mean lower credit union loan charge-offs and further reductions in loan loss provisions. So what the Fed might take away from financial institutions in lower margins, it might give back in lower loan loss provisions.
STEVE RICK is CUNA’s senior economist. Contact him at 608-231-4285.