Right around the time you receive this newsletter, we’ll all be hearing what the Fed decided to do with the Fed Funds Rate at its December Meeting. The Fed Funds Rate is the overnight interest rate financial institutions charge each other for the use of excess deposits at the Federal Reserve. Metro is currently earning between 0.00% and 0.25% from the Fed on our excess deposits, and it is the Fed Funds Rate that sets the benchmark for short-term rates at financial institutions.
Most economists and market experts are anticipating the Fed will increase rates in December. If that does occur, what is likely to happen at Metro? The answer to that question depends on how much the Fed moves rates, and what the Fed says about the likelihood and pace of future rate moves. The answer also depends on how consumers react to increases in rates. But, there are some things we know are likely to occur when the Fed begins to move rates up.
While Fed interest rate moves are intended to influence borrowing rates, deposit rates are also affected. Initially, you will likely see a near immediate increase in interest rates on what are considered to be “rate sensitive deposits”, like money market accounts and certificates of deposits. Increased rates on other depository accounts like savings accounts and checking accounts will be slower, and are not likely to include as much of the Fed Funds increase as money markets and CDs.
After money market and CD rates go up, you will also begin to see an increase in interest rates on loans, but this is where things begin to get a little less certain. Financial institutions make their money on the “spread” between the rates paid for deposits and the rates charged for loans. So, when deposit rates go up (which is what will occur when the Fed moves the Fed Funds Rate), interest rates on loans will go up as well. However, normally the Fed increases the overnight rate in an attempt to mitigate inflation that can occur when the economy is growing at a much faster pace. Today, there are conflicting inflationary indicators, and few would describe the economy as growing rapidly.
Most financial institutions currently have an excess of liquidity, meaning more deposits on hand than demand for loans. If higher loan rates cause a further weakening in demand for loans, then a smaller portion of Fed Funds Rate increases will be reflected in rates paid to depositors at financial institutions. The best case scenario for depositors is for the economy to grow at a faster pace. Stronger economic growth will result in more demand for loans and borrowers willing to pay higher interest rates for money. This, in turn, will result in a greater portion of Fed Funds Rate increases being passed on to depositors.
It should also be noted that increases in the Fed Funds Rate do not necessarily translate into increases in longer term loan rates, like mortgage loans. Long-term rates are more impacted by investor expectations of future inflation than short-term Fed moves. As a result, it is difficult to predict how much impact Fed Funds Rate moves will have on 30-year mortgage rates. Another problem today is, no one knows how the economy will react to increases in the overnight rate, because we’ve never had rates this low for this long, and we’ve never seen Fed Funds Rates increased without stronger growth in the economy.
Over the past several years, Metro has managed our loan portfolio very conservatively. So, regardless of whether interest rates increase quickly or slowly, Metro is extremely well positioned to react and offer attractive rates to both depositors and borrowers. Not all financial institutions will have the same degree of flexibility in adjusting deposit interest rates up because they took on too much interest rate risk.
Interest Rate Risk occurs when a financial institution has a mismatch between the terms of deposits versus loans. For example, if an institution is paying 1.00% interest on 36 month CDs, and charging 3.00% interest on 60 month car loans, the 2.00% spread is pretty low, but there isn’t much Interest Rate Risk because the terms of the deposits and loans are pretty close. However, an institution that is paying 1.00% on 36 months CDs can make more money by booking 30 year mortgage loans at 4.00%, but to pick up the extra spread they are taking on much more Interest Rate Risk. The extra 1.00% spread they earned by booking 30 year mortgage loans instead of 3.00% car loans will deteriorate pretty rapidly when rates go up. If the market rate for 36 month CDs goes from 1.00% to 4.00%, depositors will expect to receive that rate. At the same time, no borrowers who received the 4.00% rate on a 30 year mortgage will feel bad for the institution and offer to increase the interest rate they are paying on their home loan.
Over the past six years, Metro has operated successfully booking short-term loan and managing our balance sheet to avoided taking on Interest Rate Risk. Today, Metro has one half of the long-term, fixed rate loans as a percentage of total loans when compared to the Industry. This means as market rates do go up, we can afford to increase deposit rates because our loan rates will go up proportionately.
Because Metro is owned by our members, we value those members who deposit money as much as those members who borrow money. As we move into this period of rising interest rates, we are positioned to meet the needs of both groups.