How Economic Instability Will Impact the Banking Industry

Jim Marous:
Hello and welcome to Banking Transformed. I'm your host, Jim Marous, Founder and CEO of the Digital Bank Report and co-publisher of The Financial Brand. The economic outlook for 2022 is being impacted by rapid inflation, geopolitical shocks, rising interest rates and unemployment numbers set numerous headwinds. While rapid post pandemic growth and a strong labor market have been big wins, the benefits of the recovery could be diminished as prices rise eating away at people's pocketbooks. The question is, if the Fed must raise interest rates to higher levels to restore economic calm, could this start a recession that could actually impact the banking industry and possibly increase unemployment rates? And how does this impact not only the banking industry but the consumers who depend on us?

Jim Marous:
I'm excited to have Steven Rick, Chief Economist for CUNA Mutual on the Banking Transformed podcast. Steven will share his insights on the unprecedented economic conditions we are facing and what the future may look like. Welcome to the show, Steven. You know, As the Fed increases interest rates and economists increasingly warn that it may take a mild recession to bring inflation under control, economists question whether the ambitious spending in response to the pandemic was justified. To say the least, understanding the future of the economy is more ambitious and more difficult than ever. So, Steven, before we begin, can you talk a little bit about yourself as well as your role at CUNA Mutual?

Steven Rick:
Sure. Here at CUNA Mutual I'm the Chief Economist. That means my main role is to study the economy and try to forecast where it's going for the next three or five years, to help CUNA Mutual do their strategic planning, but also how it's going to impact financial institutions from credit unions to banks, will the economy and interest rates affect their balance sheets and income statements? So I really look at the external world and try to bring that into CUNA Mutual Group.

Jim Marous:
That's great. When we talk about the economy today, how has predicting the future become more difficult today than it was even two years ago? What's changed since the pandemic?

Steven Rick:
Yeah, I know, we've done things in the last two years we've never really seen before. We had this massive fiscal stimulus where the government was sending out three stimulus checks over the last two years, so Americans received thousands of dollars really in free money. And so right now they're sitting on a pile of liquidity at credit unions and banks are sitting on all of this excess deposits. We don't know how fast consumers are going to spend that down, but that is one factor driving demand in the economy today, which is also driving inflation to heights we haven't seen since 1981. So over 40 years, the highest inflation we've seen.

Jim Marous:
Obviously there's many components of the economy all working at the same time. Today some seem to be deploying the same direction while other components of the economy seem to provide mixed signals as to how much is going on today and the result of the government's response to the pandemic. What are you seeing with regard to not only global challenges, but just coming out of all the aspects that you talked about with the pandemic?

Steven Rick:
Yeah. With the pandemic, of course, we've had massive supply chain disruptions, and we still have it today. With COVID-19, it's not over yet. Shanghai is still in lockdown so we're seeing massive supply problems there. We're still not getting all of these, say, semi-conductor computer chips that we need to make the difference to appliances and automobiles and other things that we need. So our economists are trying to figure out, is this inflation caused by a cost-push supply-side shock? Or is it more of a demand pull, demand side shock? We have all these consumers spending. Of course we have the war taking place right now in Europe between Russia and Ukraine.

Steven Rick:
That is also causing massive shocks in the commodity markets where wheat prices are going up. And of course that could cause even famine around the world, especially like in Africa that get a lot of their food products from the Ukraine and Russia. They are both big exporters, so there's a lot of uncertainty both on the demand side of the economy and on the supply side of the economy. And basically, and hopefully, we can get that supply shock taken care of. We can get oil prices to come back down again, get inflation back down so the Federal Reserve won't have to raise rates significantly to cool down this overheating economy.

Jim Marous:
So, obviously at the forefront of this discussion about the economy are interest rates. How high and how fast do you believe interest rates will rise in the next few months or in the next year?

Steven Rick:
Yeah, that's a great question here. We always say in the economist world that the price of money is the most important price in an economy. It's more important than the price of oil. It's more important than the price of gold or the exchange rate. And of course the price of money is just interest rates. And typically economists break it into short-term interest rates and long-term interest rates. Well, short-term interest rates are mainly driven by the Federal Reserve. We call that the Fed funds interest rate, which is the interest rate that banks lend money to each other overnight. So it's very short-term lending, but it's probably the most important interest rate in the world. Last week the Federal Reserve did raise short-term interest rates by half of a percentage point.

Steven Rick:
So, right now it's still sitting below 1%, this Fed funds rate, but we do expect it by the end of this year to maybe reach 2.5%, which would be the highest since roughly 2019 before COVID. The big debate amongst economists is how high will the Fed have to raise this interest rates to cool down this overheating economy, to kind of restrain demand a little bit. Think about the economy is like a horse and the horse is galloping a little bit too fast. The Federal Reserve is trying to pull on the reins to slow this horse down a little bit. We're forecasting maybe by the end of next year, 2023, we could see the Fed funds rate at 3.5%. Now, the big question, are they going to have to go higher than that? Most economists say it's going to be difficult for the Fed to go higher than that without really disrupting the financial markets.

Steven Rick:
There are some economists out there saying the Fed may have to go to 5.5%, 6%, but we think that will really disrupt the financial markets. They're somewhat fragile right now, and that could actually cause a recession, so we don't think the Fed is going to do that. On the long end you say have the 10-year Treasury interest rate. Now the 10-year Treasury interest rate is now over 3% and rising, but most economists say that based on the global demand for the dollar, you know, the US dollar is still the world's reserve currency. So banks around the world, investors around the world, still need to hold dollars. And when they hold dollars, they buy our treasury securities and that'll basically keep the 10-year Treasury 10 of below 4% and above 3%, so kind of in that three to 4% range. So we don't expect long-term rates to really move up above 4% over the next couple of years.

Jim Marous:
It's interesting. In the past consumers didn't have as much disposable income that they have now. I mean, COVID did a few things. Number one, the government gave significant amount of stimulus to the consumer base. In addition, the consumer, because they weren't doing vacations, they weren't spending nearly as much, they're still sitting on a reserve of funds that may not impact their spending. Is it likely that this is going to take them at a higher increase in interest rates at a time when people may not want to borrow?

Jim Marous:
For instance, I'm having to refinance my car loan. Actually it was a car lease, but I have a car that's worth more now than it was three years ago when I bought it. I have a Jeep. Well, when considering whether or not to finance it, just to take advantage of the low interest rates, something you're going, "But I can buy it out now with cash." So are interest rate changes having as much of an impact on the consumer as it used to?

Steven Rick:
The biggest impact right now that interest rates are having on consumers are through mortgage lending rates. Mortgage rates have really shot up just in the last couple of months here. Right now the average mortgage rate is around 5.3%. That's up from roughly-

Jim Marous:
So it's about two, 3% higher.

Steven Rick:
Yeah. It was about 3% last year at this time. So what does that mean for the average consumer trying to buy a house today? Well, your mortgage payment is going to be about $400 more if you're buying say the medium priced house than it was a year ago. So we are already seeing a big slowdown in the mortgage market. We're seeing a lot of financial institutions downsizing their mortgage lending department. We could see mortgage originations drop by 30, 40% this year that will hurt what's called purchase mortgages where people actually are purchasing a home, but the refi market, in the mortgage market, has really dried up already. Very few people...

Steven Rick:
I mean, these are the highest mortgage rates since really 2009. You got to go back 13 years to see mortgage rates this high. So the one mechanism which monetary policy or higher interest rates impact the economy is through that interest rate sensitive sector called housing. And we are going to see a slow down in housing. Hopefully not a big crash. We don't expect home prices to fall dramatically or anything like that. Nothing like we saw back in 2008, 2009, during the housing boom and bust phase, but it is going to slow down significantly over the next couple of years.

Jim Marous:
Well, it's interesting, when you talk about home prices, we have still the phenomena of people moving from higher rent districts or higher, more home price districts to lower home price districts, because of the whole work-from-home phenomenon. And these are all these things working together that came out of the pandemic. Do you see that the continued expansion of work from home and people moving from, let's say, the coasts or the Northeast to the Midwest, do you see this is going to be impacting home prices either positively or negatively when taken in combination with the interest rate hikes? And do you think that the price of homes will continue to increase the way they have been?

Steven Rick:
Yeah. Last year in 2021, depending on which home price index you looked at, home prices rose between 16 to 20% last year. And of course in some markets like Phoenix and places like that, it rose 28, 29, 30% increase. Well, clearly that's not sustainable. It can't go on in the long run because people's incomes are not growing by 28, 29%. Most American incomes are growing 6% right now. And in the long run, that price to income ratio has to normalize. So we're going to see a slow down in home pricing. So if we did about 16 to 20% last year in 2021, we're actually still forecasting about a 9% growth in home prices this year. Now you may say, "Is that fast? Is that slow versus some long run average?" Well, the long run average in the United States is for home prices to rise about 4.1%.

Steven Rick:
So, if you buy a home here or you have children that are looking at buying a home, you can tell them, expect your home to go up about 4.1%. This year we're forecasting another 9%. Why is that? Well, just for the reasons you just described. You have a lot of these people working remotely so they're moving out of the city and maybe buying a second home. That's keeping home prices up. But you also have a demographic phenomenon called the millennial generation. Those are people between what? 26 and 40-years-old. There's 83 million of them, and they're at that age where, 26 to 40, you're getting married, you're having kids and you're probably buying a house.

Steven Rick:
And so there's still demand out there by these dual-income millennials, even though prices are at record highs and mortgage rates are the highest they've been in 13 years. They will still continue to buy. There's not much inventory out there. Not that many people willing to sell, and that's going to keep prices rising 9% this year, which I said, is double, more than double than regular 4% increase price. What do we expect for next year home prices? We do expect home prices to basically return to about a 4% growth next year. So not a dip yet, but then in the out years, going into say 2024, 2025, home prices rising but just barely. Maybe one or 2% a year, below the 4%, to try to get that price of homes to income ratio somewhere back to normal.

Steven Rick:
We're not expecting a bust in the home prices. We're not expecting a big crash like we saw in 2008, 2009. Why is that? Well, mortgage underwriting standards have been a lot better this cycle. We're not doing a lot of crazy subprime mortgage loans like we did 14 years ago where if you had a heartbeat, we gave you a loan. We're not doing that this time in the banking world. And also the unemployment rate is expected to remain below the natural unemployment rate, so a strong labor market for the next few years. So people have jobs, they keep paying their mortgage payment, so we don't expect a big drop in home prices.

Jim Marous:
It's interesting. It's going to be very difficult for the first-time homebuyer, because people have shifted where they're moving. They're bumping up the home prices, interest rates are going up, and it's getting more difficult for that first-time homebuyer, but they also have flexibility to live where they want to live if they're a work-from-home family. So at the same time that all this is going on in the mortgage market, and as we're seeing increases in interest rates, we're also seeing historically low unemployment rates at the same time that workers are leaving the workforce. How high and how fast could the cost of labor rise as a result of these dynamics?

Steven Rick:
Yeah. As I mentioned earlier, the labor market is extremely tight right now. The unemployment rate is around 3.6%. Economists consider the natural unemployment rate to be roughly about 4.5%. So we're almost one percentage point low, which means a tight labor market, which means bargaining power has shifted to the employee and away from the employer. So the employee can walk into the boss's office and say, "Hey, I want this type of pay. I want to be able to work from home. I want these benefits, or else I'm quitting." And right now we're seeing the highest quit rate we've ever seen in the United States. If you want to look at a correlation between two variables, look at the quit rate and the wage growth. Whenever the quit rate goes up, wages start to accelerate.

Steven Rick:
And right now wages in this country are rising five-and-a-half, 6%, which is one of the fastest we've seen. And of course, when wages go up, what does a firm have to do? Well, they try to raise the price of their product in order to keep their profit margin constant. If their costs are going up, they try to raise the price and that's one factor that's driving up inflation, is this increase in wage pressures. Economists like to call that cost-push inflation, because their labor costs are going up, which is pushing up inflation. So we could see wages continuing to be strong for the next few years, because the unemployment rate is forecasted to be in the middle to high 3% range for the next couple of years as this labor market remains tight.

Steven Rick:
Like I said, that's going to keep that inflation a little bit higher than the Federal Reserve would like. I know the Fed Reserve's most important goal in life is to have what's called price stability or translation, keep inflation at 2%. Well, they're not really doing that. Inflation's running about 8.6%, but they're going to try, and hopefully get the supply side working better, reduce demand a little bit, and hopefully bring that inflation down in the next few years. But higher wages could keep it up for a little bit longer, keep inflation running a little bit higher because of that cost-push inflation.

Jim Marous:
So when we talk about labor prices and the availability of skilled workers, how do you see this impacting the operating expense of financial institutions? Because they're not only impacted by inflation that rides in labor costs, but there's right now a significant labor shortage, especially as we're looking for skilled workers in the technology and the analytics and the coding areas that financial institutions may not be the first place of choice for workers. So when you look at that dynamic, how is that going to impact financial institutions overall do you think?

Steven Rick:
Yeah, right now what we're hearing from the banking world is the increase in the churning of their employees, especially among the frontline staff and lending officers, that these frontline staff are saying, "Hey, you pay me 16, 17, $18 an hour being a teller. Well, I can go work at Amazon or somewhere else and get higher wages than that." So we're seeing a big churning in the frontline staff, which really pushes up the training costs for say a bank or a credit union because you bring somebody in, you got to train them up to become a teller. It's very complicated today. There's a lot of regulations and rules about handling money.

Steven Rick:
And so just their training costs are going to go up, which pushes up operating expenses. Wages are going up, which as you know, labor costs are about 50% of operating expenses at a financial institution. So those costs are going to be rising. So one of the big issues I hear when I talk to different financial institution executives is their focus on operating expenses right now and how quickly you're going they're going to go up. This cost, with just regular inflation, just the cost of doing business is going up from their heating cost, energy cost, down to paper and pencils, inflation is pushing up the price of everything, pushing up their overall operating expenses.

Jim Marous:
Everybody's pocketbook is being impacted by rising costs of gas, food, retail goods. Is the inflation we're experiencing today more going to be permanent or temporary in the mid-term? And, just as importantly, can wages keep pace? Or will we see a net loss positioning for several years to come?

Steven Rick:
Yeah, that's a great question. Right now inflation is running around 8.6%, and I said wages are say going up maybe 5.6%. So this is about a three percentage point differential there, which means real wages, economists like to use the phrase real wages, which just means wages adjusted for inflation are falling roughly three percentage points. What does that mean? That means your purchasing power of your income this year will buy 3% less goods and services than you could have say last year. So you're actually seeing a reduction in the purchasing power of your income. That's probably going to be that way for this year and next year where inflation will be above wages growth.

Steven Rick:
But we do expect that, in the long run, maybe two years from now, that inflation will fall below the growth in wages and we'll see a little bit of a pickup where wages are growing faster than income to kind of boost that real wage up again. But it's not going to be in the short run. Basically, I say here, short run is maybe two years, but then hopefully going up three, four years, wage growth will be higher than inflation and bring that real wage back up. In the long run as economists study this, in the long run, real wages typically go up in the United States, which increases people's purchasing power, but in the short run, it's not going to happen because of the shock we've seen to inflation and wages are just not growing that fast right now.

Jim Marous:
So from your perspective on a macro basis, are we heading for a recession? If we are, when do you think that recession will happen? How significant do you think that will be?

Steven Rick:
Yeah, that's the number one question I always get when I give speeches on the economy or talk to financial executives. When's the next recession? We're actually not forecasting a recession for the next four or five years. Now I've got these nice charts that have forecast up and we're forecasting the economy to be growing above 2% for the next few years. Now why 2%? Well, that's one of those magic numbers the economists like to look at, that the US economy naturally grows 2% a year. We just naturally make 2% more goods and services due to say 1% labor force growth and 1% productivity growth. So economists do that sophisticated math. We had 1% and 1%, we get about 2% is the natural growth of the economy, and we're forecasting this year about a 3% growth. You would say, "Why is that?" Well, we got massive government stimulus still out there.

Steven Rick:
Remember we passed that 1.9 trillion infrastructure bill last year? Well, we're going to be building a lot of roads and bridges and highways for the next few years. We have a lot of inventory rebuilding to do. Now, if you go by your new car dealership in your hometown, you'll notice there's not a lot of new cars out there. They have them like "socially spaced," if you will, like a COVID situation. But we need to rebuild not only cars, but refrigerators and stoves at your local appliance store. And that's going to keep the economy moving. Plus, the average consumer still is sitting on a pile of liquidity, a pile of spending power from all those stimulus checks. So there are some fundamentals out there that hopefully will keep us out of the recession.

Steven Rick:
The biggest risk to the economy right now is the Federal Reserve. You know, Federal Reserve raising interest rates too far, too fast, but hopefully we believe Jerome Powell, he doesn't want to raise the rates too far. In fact, some people say he's going too slow and too late. And maybe he's got a little bit behind the inflation curve. So right now, we're worried about the Fed just raising rates too quickly, shoving off the demand side, kind of pulling down the demand to the point we're actually in a recession. But like I said, our forecasts right now are for no recession just because there's so many underlying factors driving the economy forward.

Jim Marous:
So let's get down to the financial institution level. Given all these crosswinds, all these mixed dynamics, do you think that financial institutions as a whole will continue their historically resilient profitability for the next few years?

Steven Rick:
You know, kind of the bottom line for cred unions, besides working at CUNA Mutual, I actually teach economics at the University of Wisconsin here in Madison, and I teach the banking courses there. I've been doing that now for about 23 years, and in the banking world you always have that kind of 1% return on assets goal. You always want to earn like $1 for every $100 in assets, under management. That was kind of the rule of thumb in the banking world, get a 1% ROA. Well, in the last few years, it's been difficult to do that. For a lot of financial institutions, the new normal, that's in that phrase we like to use, the new normal is around 0.75, where we earn 75 cents for every $100.

Steven Rick:
Now our margins kind of got a little bit tight because of this low interest rate environment. It's basically become a little bit more difficult being a money trader, which is basically what banks are, right? They buy and they sell money. They take in deposits, pay one low interest rate, and then make a loan, charge a higher interest rate. So their margins are the difference between those two. The cost of funds and their yield on assets have been very tight. Even though last year banks had some decent earnings, they made a lot of mortgages, they had what's called a lot of gains on sales of those mortgages when they sold them off to Fannie Mae and Freddie Mac. Well, that's going away this year.

Steven Rick:
Credit risk has been non-existent for the last few years so they haven't made a lot of provisions for loan losses. That expense category has been basically zero, in fact, negative last year, so they've kind of boosted their earnings last year. This year we expect a kind of reversion to the long run average year. We expect earnings to come down this year, mainly because provisions for low losses are going to go back up. We're not going to see as many mortgage originations, so that side of the business is going to slow down significantly, and just very, very tight margins because of this current low rate environment. Now rates are going up, which is good, typically good news for banks, but a lot of our loans aren't going to reprice very quickly. We've put mortgages on our balance sheets.

Steven Rick:
Well, they're going to extend. There's a little bit of what's called extension risk that these loans are going to be on our books for many years, so we have some interest rate risk that we're going to be facing, and that's just basically, we're worried about our cost of funds. What are we paying on a one year CD to the bank customer compared to what we're earning on those loans? And if you remember what happened in the 1980s with the savings loan industry, they got caught in this interest rate risk where their cost of funds were rising faster than their yield on assets, and we had a big hit to the savings and loan industry because of that. But there are some good signs out there. I mean, interchange income for banks should go up this year.

Steven Rick:
Every time you swipe your debit card or credit card when you buy something, banks make some money every time you do that. And with the opening up of the economy, as COVID-19 hopefully fades away and people start traveling again, they'll start swiping their debit cards and credit cards, will make money there. Credit card lending we expect to come back strong. Home equity lending is coming back very strong. So there are some good signs out there for the banking world, but there are some headwinds for banks, especially when it comes to some of their operating expenses as we talked about and their provision for loan loss expense will be coming back after two years being on a hiatus because of very little credit risk.

Jim Marous:
So given your concept that financial institutions are going to be less profitable overall than they have been historically, we're also at a time when financial institutions need to invest in their infrastructure that have been ignored for decades in order to be competitive, especially in the digital world. Do you see some major disruption in the future of the overall industry where we're going to see either mergers and acquisitions are actually folding of traditional organizations that really are having a difficult time keeping up with the investments at a time when profitability isn't growing at the rate it used to?

Steven Rick:
Yeah, that's a great point. COVID-19 has really accelerated the digitization of the banking system, mobile banking, online banking. And so medium and say small banks who don't have digital capabilities, we are already seeing a pickup in merger activity in smaller size institutions who maybe don't have the earnings, the asset growth, the customer base growth as they would expect, and are looking for merger opportunities to basically better serve their customers. We're also seeing that in the credit union world where more credit unions are now looking for merger opportunities. So, yeah, COVID has really accelerated that.

Steven Rick:
And, of course, as you know, it's very difficult to find those data scientists to come in and do the data analytics that you need today in order to compete effectively in that when you're dealing with some of the larger banks from Citibank, Wells Fargo Bank, Bank of America, who have very good online banking, very good mobile banking, and more and more people because of COVID got used to doing mobile banking at home because they weren't going into the branches because they were shut down because of COVID-19. So we have seen this acceleration, so it is going to change the competitive landscape over the next couple of years here.

Jim Marous:
So from an overall perspective and our final question, do you see the financial institutions industry itself disrupting significantly? Or do you think that the industry as a whole is going to be able to weather the storm as it is today?

Steven Rick:
The banking industry is extremely resilient. There are some very smart people working in banking and they adapt very quickly to changing circumstances. So, no, I mean, I believe the US banking system is very healthy today. They've been extremely well capitalized here in the United States. So they got a lot of capital. I mean, they have a very strong balance sheet. They're sitting on a pile of liquidity, so they're very strong on the asset side of the balance sheet too, with very good quality loans for the most part.

Steven Rick:
A lot of liquidity, strong capital, not much debt of their own. So we got a very strong, healthy banking system and they will weather this. You know, COVID-19, they weathered extremely well, and they will weather the Federal Reserve, the higher interest rate that's coming because the structure of their balance due is strong. Even though I said earnings are going to be under a little bit of pressure this year, they're still going to be profitable. They'll be still pulling a decent return on asset, which will allow them to keep their asset base growing into the future.

Jim Marous:
Steven, thank you so much for being on this show today. I really appreciate your perspective and a view into the future. I know that it's a risky business to be a futurist or making predictions nowadays, especially given what we've gone through for the last two years, but with everything changing so fast, it's sometimes difficult to actually get a grasp of all the different dynamics and what the final outcome will be. Appreciate you being on the show today.

Steven Rick:
Thank you, Jim.

Jim Marous:
Thanks for listening to Banking Transformed, just rated as a top banking podcast and winner of three international awards for podcast excellence. If you enjoyed today's interview, please give our show a five star rating on your favorite podcast app. Also be sure to catch my articles on the Financial Brand and the research we're doing for the Digital Bank Report. This has been a production of Evergreen Podcast. A special thank you to our producer, Leah Longbrake, audio engineer, Sean Rule-Hoffman, and video producer Will Pritts. I'm your host, Jim Marous. Until next time remember, it was such a complex and fast changing economy, forecasting had become something between tremendously difficult and virtually impossible.