Personal Finance Blog By MoneyRates - June 2010

Bank economists say we're on the path to a solid recovery, a double-dip recession is highly unlikely, and they expect the Fed will start raising interest rates next year.

The prediction about rising interest rates was unanimous among the dozen members of the American Bankers Association Economic Advisory Committee, which recently released its views on how things are going in the economy.

The group predicts the federal funds rate, now under the 0.25% ceiling of the current Fed target range, will rise to a median estimate of 1% by this time next year and 1.5% by the end of 2011.

What About Consumer Bank Rates?

The economists expect a "modest increase" by year-end 2011, with 30-year fixed mortgage rates rising to 6.15% and the 10-year Treasury to 4.4%. The current average mortgage rate is 4.75%, with an average 0.7 in points and fees, by Freddie Mac's latest reckoning.

Other predictions include:

• Consumer spending will grow by an average of 3% this year and next.

• Bank lending to business and consumers will pick up this year and even more so next year.

• Inflation will slow this year and then rise slowly to 1.8% in 2011.

• Low commodity prices, Treasury rates, and mortgage rates will offset impacts of the European economic crisis on the American economy.

Of course joblessness remains the key concern. The committee predicts the US economy will add 2.2 million jobs this year and another 2.5 million jobs next year. That sounds like a lot until you consider 8 million jobs were lost in the recession. Unemployment will drop -- but slowly -- from the current 9.7% to 8.5% by end of next year, the group says.

That means slow gain and continued pain.

Committee Chairman Stuart G. Hoffman described the recovery as a "lengthy rehab process."

As banking reform legislation goes through the conference committee process designed to reconcile differences between the House and Senate versions of the bill, it increasingly appears there is more going on than just reconciliation -- new twists are being added.

A significant example last week was the decision to add changes in FDIC deposit insurance to the bill. The proposal would make the $250,000 limit, which was temporarily increased from $100,000 during the banking crisis, permanent. It also would make the higher limit retroactive to cover any failures in 2008 that occurred before the first temporary increase in the limit.

More protection sounds like a clean win for depositors, but it's a little more complicated than that. There is a cost to boosting insurance levels, and that cost could help keep bank rates down in the future.

FDIC insurance is funded by levies on all participating banks. The higher this cost becomes, the less banks can afford to pay depositors in the form of interest. In other words, the cost of FDIC insurance indirectly comes out of savings account rates, money market rates, CD rates, etc.

Having a bigger safety net does not always encourage safer behavior, and it remains to be seen whether the final legislation will really make banks more stable, or just expand plans for what happens when banks fail. In particular, the retroactive insurance increase seems like bad policy --it extends a protection the system was not funded to provide, and by precedent may create an even greater implied obligation going forward.

Finally, another potential danger of overreaching by the conference committee is that the final version of the bill will still have to pass in the House and Senate. Straying too far from the original versions of the legislation could jeopardize the eventual passage of the bill.

The stock market had a big day yesterday, and has been generally trending upward for the past week. This relates to bank rates because optimism in the market often translates into higher interest rates. Indeed, bond yields have moved upward lately. So is this the movement bank depositors have been waiting for?

Don't count on it. The market's rally has all the earmarks of a mood swing, and thus could be pretty fragile.

In that sense, even the market's recent success is reason for suspicion. This hasn't been a steady climb built rationally on a succession of positive economic news items. Rather, the market has lurched forward in big chunks, just as it often lost money in big chunks in May and early June. There have even been occasions when there have been big gains and then big losses throughout the course of a single day.

Notably, all of this has occurred without any particularly meaningful news events. So, the market seems more like it is running on emotion, which makes it especially vulnerable to shocks.

This means that it will take more than sporadic market rallies to get savings account rates, money market rates, and CD rates moving upward. Given the severity of the recent recession and the halting, uncertain nature of the recovery, expect banks to be especially cautious about raising bank rates. National averages may not move upward until there is a clearly-established pattern of strengthening economic data.

That makes this an important time to shop actively for bank rates. Bank policies toward rates will vary greatly in their aggressiveness, so customers need to find the most forward-looking banks.

In releasing its latest poll on consumer spending, Gallup coined a new syndrome with which most of us can relate: "frugality fatigue."

Who, after all, hasn't grown tired of clipping coupons, putting off big purchases and saving every spare dime, only to find savings rates at minuscule levels during the recession?

Unfortunately, the rich apparently are the only ones who can provide themselves with the antidote.

Upper-income Americans' self-reported spending jumped 33% last month from April, reaching $145 per day, versus the previous month's $109 per day. It was the highest monthly average since November 2008.

The self-reported spending of middle- and lower-income Americans, though, remained flat at $59 per day.

What caused the wealthy to step up their spending? Gallup researchers theorize that many upper-income consumers have the wherewithal to increase their spending, but had been holding back due to economic uncertainty.

"It could be that many upper-income consumers are experiencing 'frugality fatigue,'" Gallup reports. "That is, they are simply tired of cutting back and want to go back to spending -- maybe not as freely as they did prior to the recession, but at higher levels than they did last year, when frugality was commonplace."

Spending Impact on Interest Rates

Any increase in spending is good news for the economy. Spending creates demand, which creates more jobs, and as the economy heats up, savers may finally be rewarded with higher interest rates on CDs, money market and savings accounts.

But it could be a while before middle-income folks return to spending.

In a separate Gallup poll, half of Americans said last month they were feeling better about their financial situation, fewer than in April, and that worsening attitude is holding so far this month. The waning optimism could be due to the stock market slide in May, or even concerns over the European debt crisis, Gallup said.

Consumer confidence rose last week, even as figures were released showing that retail sales fell during May. For bank rates -- and the economy -- that's not an even trade-off.

Money market rates, savings account rates, and CD rates remained pretty much unchanged, probably because they don't have much further to fall. Bank rates need tangible evidence of economic progress before they can get up off the mat.

On that score, you might think that a lift in consumer confidence was good news, but the consumer confidence index often gets more attention than it deserves. Confidence matters in the short run, but fundamentals like jobs, incomes, and sales are what create sustainable moves in the economy.

In terms of fundamentals, the report that retail sales lost 1.2% (seasonally adjusted) in May is a setback, but not an altogether surprising one. May's decline more than wiped out the 0.6% gain in April.

While the drop in retail sales surprised forecasters, the reason it shouldn't be seen as a shock is that there has not yet been enough progress in the employment market. Sales growth can be powered in two ways -- by income growth, or by the willingness of consumers to spend a greater share of their incomes, which often involves borrowing. Until employment picks up, we can't expect to see much in the way of income growth, and with households already strapped by debt and with lending standards having been toughened, a rise in borrowing isn't in the cards either.

So, confidence rose and sales dropped. Since the former is perception and the latter is reality, that's a net loss for bank rates.