The Federal Reserve’s 2023 strategy to combat record inflation in the United States was largely marked by a parade of federal funds rate hikes and a storm of uncertainty among financial lenders and investors alike. As a much-needed pause for air, in December 2023, the Fed announced its decision to maintain the interest rate paid on reserve balances at 5.4%, inching closer to a soft landing for the economy.
The Fed’s policies directly influence the economic environment and could impact credit unions, affecting everything from lending rates, savings rates, financial planning, and overall market behavior. In light of these unknowns, here are three things for credit unions to consider as they manage interest rate risk and strive to find success in the face of volatility.
Pause and reflect
While not always perfect, historical data plays a crucial role in preparing for possible scenarios and predicting future outcomes. The approach taken by the Fed has so far been in line with its historical behavior in similar circumstances, suggesting that modeling and forecasting are imperative to understanding and mitigating likely financial risks.
For example, 2006 marks the last time the federal funds rate was over 5%. Ultimately, it rose to 5.25% and remained at that level for an entire year, driving demand for better rates and return on deposits. This resulted in the cost of funds for credit unions staying above 3% through 2008. While history is not always destined to repeat itself, it’s worth reviewing how a similar 2006-2008 scenario could impact your deposit migration.
Review and adjust ALM
Considering the Fed’s recent rate hikes, credit unions should periodically review and update the model parameters and tolerance levels in their asset liability management (ALM) policy. Interest rates represent the most common stress test for ALMs, mainly due to the sweeping impacts interest rates have on cash flow and monthly projection models. A comprehensive ALM framework will include a plan for monitoring interest rate risk and outline strategies for managing the maturity and repricing of assets despite changing interest rates. This should also involve monitoring risks associated with repricing, prepayment and extensions, and yield curve.
Anticipate and innovate
While stabilizing fed rates could indicate calmer waters ahead, assuming the increases in the cost of funds or interest rates are over could be a grave mistake. It’s important to remember that rates could continue to increase or suddenly drop, deposits may dissipate, credit risks could amplify, or a recession could rear its head. Volatility often leads to a reactive mindset; however, pausing to discuss likely outcomes and actions can help bring clarity and create space for proactive strategies among the Board and leadership. Finding innovative responses to various scenarios could make all the difference in mitigating likely perils and minimizing interest rate risk exposure. For example, pausing to consider the long-term implications of the institution’s deposit pricing strategies on future deposit acquisition could make a monumental difference in successful modeling and mitigation.
Despite the seemingly unpredictable impacts of the Fed’s inflation policies, credit unions can take steps to prepare and find positive opportunities within this uncertain risk environment. If you want to learn more about how effective modeling and a comprehensive ALM framework can help you, please contact our credit union team.
Samantha Pedersen joined ARB in 2004 and currently serves as a director. She provides business advisory and attest services primarily to credit unions, commercial businesses, manufacturers, and nonprofit organizations. Sam is responsible for coordinating the training and implementation of Financial Accounting Standards Board (FASB) updates at ARB.