Fed rate hike signals fresh opportunities ahead

Experts always seem to be discussing a possible rate hike by the Fed, but after years of talk, the increases are beginning to happen. In March, the Fed approved a .25 percent rate hike, the first increase since December 2018.

The Federal Reserve has kept interest rates close to zero as a way of stabilizing the U.S. economy during the Covid-19 pandemic. Now, however, Fed officials indicate that they plan to initiate similar rate increases at each of their remaining six meetings in 2022.

These steps are being taken to tame inflation by making it more expensive to borrow. Inflation rates in the U.S. today are near a 40-year high, according to a March 16 article in The New York Times.

“That small change,” write the authors, “carries a major signal: Policymakers have fully pivoted to inflation-fighting mode and will do what is necessary to make sure price gains do not remain hot for months and years to come.”

The good, bad and ugly of rate hikes

The Fed’s rate increase has a number of implications for community banks and credit unions, not all of which are self-evident. Not only do interest rates affect what banks and credit unions charge each other for loans, but when the Fed raises its rates, banks usually follow suit and raise their prime rate, too.

The good news for banks is that their profitability tends to increase as interest rates trend higher because the yield on cash holdings is greater. And yet all the news is not necessarily positive. For many financial products that banks offer consumers, higher interest rates can be a mixed bag:

• Credit cards. With a rate increase, debt on credit cards gets more expensive for consumers and banks make more money from the interest they collect on outstanding balances. Another effect of a rate hike is that banks may see more consumers taking out personal loans to consolidate credit card debt when rates get too high.
• Mortgage loans. While mortgage rates are not always tied to the Fed’s decisions, a rise in interest rates often makes adjustable-rate mortgages (ARMs) less attractive relative to fixed-rate mortgages. Rates for ARMs are modified once a year, and consumers will see an increase in their monthly payments when a rate hike occurs. Because the Fed has signaled a series of hikes in the months ahead, it’s likely that many borrowers with ARMs will try to move to a fixed-rate mortgage sooner rather than later. (While borrowers with ARMs are most directly affected by an increase in interest rates, the average rates of fixed-rate mortgages will almost certainly climb, too.)
• Automotive loans. The cost of auto loans will rise with the rate hike, creating a ripple effect that could go a few different ways. If car loans are more expensive, people may postpone buying cars. Decreased demand for cars could lead to the prices of cars becoming depressed, which then might create additional demand for auto loans. Projecting exactly how higher interest rates will affect auto loans is a challenge. 
• Loans, generally.  It would stand to reason that customers would hesitate to take out loans in a rising interest rate environment, but the opposite can happen, too. Rising rates tend to signal a strong economy. Optimism takes hold and there may be a surge in both consumer and commercial loans as individuals and businesses rush to lock in loans before rates spike again.
• Savings accounts and CDs. Generally speaking, savers benefit when the Fed hikes rates and suffer when the Fed cuts them. With a rate hike, banks can expect consumer demand for certificates of deposit to rise, especially for short-term CDs. And although a rate hike should benefit savings accounts and CDs offered by financial institutions, this isn’t always the case. Internet banks are notorious for offering higher rates than brick-and-mortar banks, luring customers away; as a result, community banks may not stand to benefit as much from a bigger appetite for savings accounts and CDs as they once did.
• Bank stocks. When investors take notice that rising rates are leading to higher profits, the value of bank stocks tends to increase. This, in turn, can lead to higher credit ratings for banks, making it easier to borrow and to lower their rate—which then leads to even greater stock value gains.

Higher risk tolerance?

Rising interest rates—accompanied by a strong job market and a robust economy—can lead bankers to rethink their risk tolerance for customers who lack pristine credit histories. The thinking often goes: “If you have a job and the economy is good, making monthly payments should be easy.” This is just one of many examples of the new types of thinking a rate hike can usher in.

While understanding all the repercussions of a Fed rate hike is never easy, it makes sense to begin considering some of the fresh opportunities your bank or credit union might want to pursue going forward.