Will the Fourth Time Be a Charm?

The Fed’s QE-4 plan will keep pressure on CUs’ net-interest margins.

February 11, 2013

The Federal Reserve Board announced two changes to how it will carry out monetary policy in the future to achieve maximum employment and an inflation rate of 2%. Both changes will affect the duration and magnitude of the current squeeze on credit unions’ net-interest margins.

First, the Fed set quantitative thresholds for when it will raise interest rates.
It kept the target range of the federal funds rate at 0% to 0.25% until the unemployment rate falls below 6.5%, projected inflation over the next two years exceeds 2.5%, and longer-term inflation expectations become untethered (“Federal Reserve’s policy thresholds”).
In effect, the Fed is saying it’s willing to accept an inflation rate that is higher than its target of 2% in an attempt to lower the unemployment rate. The agency views these thresholds as consistent with its earlier policy guidance stating it would not raise short-term interest rates until mid-2015.
The announcement of thresholds is an attempt by the Fed to improve its communications with the public. By targeting widely followed economic conditions instead of a date-based policy, the markets should be better able to anticipate monetary policy changes.
Second, the Fed announced it will purchase $45 billion per month in Treasury securities. This replaces “Operation Twist,” the agency’s maturity extension program, which was scheduled to expire at the end of 2012. This is an attempt to keep long-term interest rates low to stimulate the housing sector and the overall economy.
This new asset-purchase program has been dubbed QE-4 because this is the fourth time the Fed has implemented a “quantitative easing” scheme.
QE-4 will increase the size of the Fed’s balance sheet each month due to the creation of new money. Technically speaking, excess reserves are created in the banking system.
This is different from Operation Twist, which sold $45 billion in short-term Treasury bonds and notes each month to raise funds to purchase $45 billion of long-term Treasury bonds. In that case, no new money was created.
The Fed also said it will continue to purchase $40 billion of mortgage-backed securities each month. These purchases will increase the agency’s balance sheet from around $3 trillion today to $4 trillion by year-end 2013.
These changes could cause the Treasury yield curve to stay the same or flatten further in 2013—causing most credit unions to experience even lower net-interest margins.
Credit union cost of funds are approaching zero as maturing share certificates reprice into today’s lower interest rates. But asset yields are falling faster as old loans and investments reprice into today’s record-low interest rates.
As a result, credit union net-interest margins fell to 2.91% of average assets in the third quarter of 2012 from 3.12% in the third quarter of 2011. We expect credit union net-interest margins to fall another 20 basis points (bp) in 2013 as asset yields fall another 30 bp and funding costs decline only 10 bp.
With today’s unemployment rate around 7.7%, it will be a couple more years before the Fed raises short-term interest rates and, in turn, credit union asset yields and net-interest margins.
STEVE RICK is CUNA’s senior economist. Contact him at 608-231-4285.