Mercator Blog

The End of an Era—Rising Interest Rates Finally Return to Banking
Date: December 17, 2015
Research Team
The wait is over to learn when the Federal Reserve will begin to raise the benchmark federal funds rate. Banking leaders must now dust off their rising-interest-rate procedures manuals. Among important questions are these: At what pace will subsequent rate rises occur? What will be the duration of rate hikes? And: How high will rates rise over the next few years?

The answers to these questions are critical for meeting revenue and profitability targets. After all, it’s been nearly a decade since the U.S. economy last experienced rising interest rates, and many of today’s bank and credit union employees have never worked in such an environment. For them, planning for potential changes in interest-sensitive products, like deposit and credit offerings, has not been top of mind.

The economic climate of the past few years may have caused some institutions to be somewhat blasé about interest rates, since they remained extremely low and flat. For institutions whose offerings are weighted toward fixed-rate deposit products, an expansion of the variable-rate loan product set can offer built-in margin protection against rising rates as well as the potential to be more competitive in markets where such products are prevalent.

Banking industry leaders often look at yields in short-term financial products to gauge possible movements in near-term interest rates. Recently, yields on short-term government debt, including T-bills, have been rising. This reflects widespread assumptions that the Fed may have several increases in mind over the next year or so.

While a look at short-term yields is important, banking leaders typically focus on the performance of 10-year notes and 30-year Treasury bonds. These longer-duration financial products offer a glimpse of the market’s projection of long-term rates and are often used as a benchmark for credit and long-term loan products like mortgages.

It’s likely that much will be written in the coming days and weeks about the possibility that rising interest rates may spark inflation that is higher than intended. It’s important to keep in mind, however, that although the Fed has stated that its goal for interest rates and inflation rate is 2%, it has yet to achieve that goal when real rates (which include adjustments for inflation) are taken into consideration.

Even though growth in the economy continues, it has been at a modest pace in several key market sectors, industries (particularly Energy), and geographic areas. This would leave room for increases in interest rates without setting off higher levels of inflation, at least in the short term. But macro and micro economic forces are many and varied, with many moving parts. Because of this, banking leaders should be intently watching key economic indicators and their potential effect on their banks and credit unions.