How banks and consumers are responding to the distant potential of Fed rate cuts

The optimism around the ease in the Federal Reserve’s combat against inflation has dissipated just one quarter into the current year.

Following the release of the Fed’s most recent projection materials in mid-March, which still foresaw three 25-point rate cuts by year-end, subsequent economic data has dampened any expectations of immediate rate reductions.

During a recent policy forum, Fed Chair Jerome Powell cautioned that interest rates might linger at elevated levels for a longer duration than initially anticipated. “The recent data have clearly not given us greater confidence, and instead indicate that it’s likely to take longer than expected to achieve that confidence,” he remarked. Powell affirmed the Fed’s readiness to uphold the current level of restraint for as long as necessary.

After a phase of enthusiasm surrounding rate cuts, markets are now responding to these developments, with earlier hopes of three rate cuts in the year dwindling to uncertainty over whether any cuts will materialize at all.

As each month passes, the continued stretch of high-interest rates is intensifying pressure on both banks and consumers alike.

While previous quarters witnessed significant profit increases for many major banks, primarily driven by higher interest rates, Net Interest Income (NII) declined for some incumbent institutions, impacting their financial performance in the first quarter of 2024. In fact, the resurgence in investment banking activity was the saving grace for the earnings of major banks in the first quarter.

The impact of sustained higher rates has already permeated banks’ Net Interest Income as borrowing by businesses and consumers declined, coupled with higher funding costs for banks. With several Fed officials no longer seeing a pressing need to cut interest rates, the decision to maintain higher rates for an extended period is expected to further tighten the squeeze on banks, with potential ripple effects on end consumers.

Many banks have taken proactive measures by bolstering their loan loss reserves in anticipation of sustained weakness in specific portfolios, including credit cards and commercial real estate. For instance, in the fourth quarter of 2023, Citi recorded $3.78 billion in combined charges and reserves. By Q1 2024, the bank had reserves of nearly $22 billion, with a reserve-to-funded loan ratio of around 2.8%.

Conversely, consumers are grappling not only with expensive borrowing costs but also with a significant portion experiencing loan rejections. 

According to a recent Bankrate survey, half of Americans who applied for a loan or financial product since the Fed commenced raising its key benchmark rate in March 2022 have been denied, with 17% facing multiple rejections. Mainly fueling this trend is the noticeable surge in delinquencies across all credit tiers and a broad spectrum of credit products, including mortgages, credit cards, personal loans, and auto loans.

These rejections are particularly challenging as many households rely on credit lines to cushion the impact of rising prices, from obtaining new credit cards (14%) to securing personal loans (10%). To secure the necessary credit, nearly one in four (23%) applicants who faced denials pursued alternative financing options, such as cash advances or payday loans, which often come with exorbitant interest rates, thereby affecting their overall financial health.

Millennials and Gen Z shoulder the burden of credit denials the most, nearly on par with parents having children under 18. The younger generation, especially, faces added complexity due to the combination of loan or credit rejections and the necessity to establish their credit history. Therefore, many Gen Zers prefer debit cards over credit cards due to limited credit card access and lack of familiarity. Around 69% of them use debit cards daily or weekly, compared to only 39% who frequently use credit cards.

Securing loans or credit has become increasingly challenging for consumers compared to pre-pandemic times in the wake of post-pandemic inflation and the fallout from historic bank failures in early 2023. Amid this backdrop, experts offer differing perspectives: some believe banks can explore alternative avenues such as fintech partnerships to extend credit access to new-to-credit or thin-file customers. Others, despite the Fed’s delay, are hoping for a more favorable climate ahead. “My expectation is that over the course of this year, we will see inflation move back down,” Powell added.