By Matthew Jacobsen

After 7 years of historically low rates, the Federal Open Market Committee (FOMC) increased the Fed Funds target rate by 25 basis points. The committee cited various positive economic data as its basis for the action. However, the press release of the announcement also included the caveat, “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” Clearly the FOMC is warning readers not to expect a repeat of the events of 2004/2006 when the target rate was increased by 425 basis points spanning over 24 months.

One specific economic data trend of 2015 that impacts credit unions was the gradually increasing personal incomes. A continuation of this particular data point would potentially be supportive of higher personal consumption and related borrowing by consumers. As a result of higher consumptions, auto sales in 2015 were very strong and are expected to remain healthy going into 2016.

However, other noteworthy economic data points of 2015 indicated some headwinds, particularly in more recent months. These data points should at least temper expectations of accelerating economic growth in 2016. Manufacturing activity in several regions of the country has dropped sharply and the oil sector continues to be volatile. The service sector of the economy shows modest growth and as many economists note, is a much larger contributor to GDP than manufacturing. Retail sales generally disappointed during the fourth quarter of 2015 as many were expecting the year’s gradual monthly increases in personal incomes and tighter labor markets to result in stronger retail sales than what was experienced. Overall annual growth in business sales has been slowing as the overall inventory to sales ratio has been increasing in recent months.

How should one interpret the mix of economic data in 2015 and what may it mean for 2016? Does the FOMC press release give an all-clear signal that we are at the beginning of a gradual but sustainable series of Federal Funds target interest rate increases over the next several years?

Three potential interest rate scenarios to consider in 2016:

Scenario 1 – Many economists and FOMC individual members are now forecasting a series of very gradual rate increases over the course of the next several years in the Federal Funds target rate. Futures markets are also reflecting this outcome, albeit to a modestly lesser degree at the time of this writing. Assuming the rate of inflation were to move closer towards the FOMC’s targeted rate of 2%, one would expect a gradually increasing Federal Funds target rate and a U.S. Treasury yield curve that gradually increases and steepens as higher inflation expectations are realized and factored into longer-term rates.

Scenario 2 – Given recent economic weakness, an inflation rate below the FOMC’s target, and the flattening of the U.S. Treasury yield curve, did the FOMC make a policy error by increasing the Federal Funds target rate at the December 2015 meeting? Regardless of whether this turns out to be a policy mistake or not, a second possible scenario is that rates in general increase at a much slower rate than scenario 1 and rate increases could potentially stall. Under this scenario, it would not be expected that rates return to more “normalized” levels anytime soon.

Scenario 3 – In spite of the recent FOMC action and press release, many do not see the economy as being strong enough to support a gradual and sustainable rate increase at this time. Economic data points, such as the recent GDPNow™ trend, manufacturing data, and some global economic data, provide enough of a concern that a scenario where the FOMC reverses course should be considered. This scenario could evolve if some of the recent economic weaknesses were to spread to other areas of the economy, (such as the service sector), and turn out not to be transitory (as is often claimed). This could potentially happen with no further rate increases or possibly a few more modest increases before the FOMC reverses course. In this scenario, one would expect a return to the prior 0% to .25% Federal Funds target range and a U.S. Treasury yield curve that remains flat and potentially flattens further.

Regardless of which scenario you think more closely estimates the future, the current expectation at this time is that if further increases in the Federal Funds target rate occur, they will likely be very slow, modest, and accompanied by a cautious tone.