What Community Banks Need to Know About the Fed's Interest Rate Policy

7/15/2025 - By Paul Allen, CPA, Director and Sarah Oliver, CRCM, Director

The Federal Reserve’s monetary policy continues to shape the financial landscape, with community banks feeling the impact most acutely. As of June 2025, the Fed has held the federal funds rate steady at 4.25%–4.50% for the fourth consecutive meeting. New economic data, particularly stronger-than-expected job growth, combined with persistent inflation and rising trade tensions, is delaying anticipated rate cuts and driving the Fed’s more cautious monetary stance.

For community banks, this environment presents a complex set of challenges. Prolonged margin pressure, fierce deposit competition, and rising credit risk are converging, demanding strategic recalibration in both risk management and operational planning.

The Fed’s Current Position: Caution in the Face of Conflicting Signals

The Federal Reserve has kept rates unchanged since late 2024, adopting a “wait-and-see” posture as it monitors inflation, employment trends, and geopolitical developments. Despite market and political pressure to ease policy, Fed Chair Jerome Powell has reiterated that the current rate stance remains “in a good place” and allows the central bank to respond quickly as conditions evolve.

While the Fed’s June projections indicate that a median of FOMC members foresee one or two quarter-point cuts before year-end, these projections are not formal commitments. Rather, they reflect individual expectations in a highly uncertain environment, one in which policy flexibility is paramount.

Key Economic Indicators: Mixed but Resilient

Recent economic data has presented a complicated picture for policymakers and financial institutions alike. While inflationary pressures persist, several core indicators continue to show unexpected strength. This mixed outlook is central to the Fed’s decision to hold rates steady and has direct implications for community bank planning.

The labor market remains stronger than anticipated, with government hiring contributing to monthly payroll increases that have consistently exceeded forecasts. Unemployment remains low, at 4.1% in June 2025. This ongoing resilience is one reason why the Fed has held off on reducing rates, as it weakens the case for preemptive stimulus.

While year-over-year CPI growth has moderated to around 2.4%, inflation remains above the Fed’s 2% target. Economists widely expect renewed upward pressure in the months ahead due to newly implemented tariffs and continued supply chain adjustments. The Fed’s measured approach reflects the uncertainty around these factors. 

Consumer Behavior: Implications for Balance Sheets and Funding Strategy

Elevated borrowing costs—particularly in auto, credit card, and mortgage markets—continue to suppress consumer loan demand and reshape asset-liability dynamics for community banks. 

Meanwhile, rate-sensitive depositors are shifting toward higher-yielding vehicles such as online CDs and money market alternatives. This has compressed traditional core deposit growth, increased deposit betas, and complicated long-term funding strategies, particularly for institutions with a legacy retail footprint. As savers grow more yield-conscious, banks must reassess pricing strategies and segmentation models to retain funding without overspending on rate.

Community Bank Impacts: A Difficult Balancing Act

The current rate environment is forcing community banks to navigate multiple, overlapping challenges. Profitability, funding stability, and credit quality are all under pressure, often in ways that require trade-offs. The first and most immediate concern: margin compression.

Net Interest Margin Compression

Community banks, who have traditionally benefited from higher net interest margins (NIMs) than their larger counterparts, are facing increasing pressure. Rising funding costs and constrained loan demand are eroding those margins. 

Historically, large banks have reported NIMs in the range of 2.5% to 3.5%, with recent data showing averages around 3.2% to 3.3% as of Q4 2024. Community banks, by contrast, have typically seen NIMs in the 3.5% to 4.5% range, though that high end has become less common in the current rate environment. In Q4 2024, the average NIM for community banks was 3.44%, and ticked up slightly to 3.5% in Q1 2025. As deposit costs climb and loan yields flatten, the gap between large and community bank NIMs is narrowing, raising questions about the sustainability of traditional profitability models for smaller institutions.

Deposits: Competition and Regulatory Scrutiny

Deposits remain a top concern for community banks. In a high-rate environment, consumer rate sensitivity increases significantly. As a result, banks must offer more competitive products or risk losing funding. Regulators have also increased their focus on liquidity management, elevating the strategic importance of stable deposit bases.

Loan Demand Softens

The rate environment continues to dampen loan demand across key sectors. Manufacturing employment has weakened, and many businesses are delaying capital investments and hiring decisions amid tariff uncertainty. This hesitancy directly affects commercial lending pipelines and limits growth opportunities for banks.

The Fed–Mortgage Rate Relationship: Strategic Implications

The disconnect between Fed policy and long-term mortgage rates highlights how investor sentiment, market volatility, and geopolitical uncertainty now dominate yield curve dynamics. While the federal funds rate remains a directional anchor, persistent turbulence in the 10-year Treasury market and shifting inflation expectations have kept mortgage rates elevated.

For community banks, this environment introduces pricing risk in mortgage pipelines and complicates execution in the secondary market. Institutions should revisit rate-lock policies, monitor margin compression on held-for-sale loans, and refine hedging strategies to address duration drift and basis risk, especially as macro uncertainty persists.

Action Items: How Community Banks Can Respond 

In light of these evolving pressures, community banks must reevaluate core strategies across balance sheet management, risk oversight, and operational execution. The following priorities can help institutions adapt to sustained interest rate volatility and position themselves for long-term resilience. The first step is acknowledging that elevated rates may persist longer than initially anticipated.

Preparing for a Prolonged High-Rate Environment

Rate cuts—if they occur—are likely to be gradual and insufficient to meaningfully reduce funding costs in the near term. Community banks should prepare for ongoing margin compression and reassess their balance sheet strategies accordingly.

Interest Rate Risk Management Must Evolve

Traditional asset-liability management (ALM) approaches may not fully capture today’s market dynamics. Deposit betas, loan repricing behavior, and investor expectations have all changed. Banks need robust scenario analysis capabilities that model multiple interest rate paths and their impact on earnings and capital.

Credit Risk Models Require Ongoing Validation

Risk models developed under more stable conditions may not adequately reflect the realities of 2025. Community banks should routinely validate and adjust their credit models to account for updated macroeconomic inputs, especially in high-risk portfolios such as CRE. Regulatory scrutiny in this area is increasing, and outdated models may not withstand examiner review.

Sharpen Relationship-Based Strategy

In the current environment, profitability is increasingly concentrated among institutions with high relationship deposit concentrations, low funding volatility, and strong cross-product engagement. 

Community banks should refine their segmentation models to prioritize deposit-rich households and commercial clients with multi-product utilization. By integrating behavioral data and predictive analytics into customer outreach, institutions can identify at-risk relationships, expand wallet share, and reduce rate sensitivity across the portfolio, without engaging in a rate race that undermines long-term NIM stability.

Targeted Technology Investment

Strategic technology investment is now a core driver of operational leverage. Community banks should prioritize platforms that support dynamic ALM modeling, real-time liquidity monitoring, and predictive credit analytics, while also enabling scalable customer engagement through integrated CRM and digital banking solutions. 

Efficiency gains must be measurable, risk-aligned, and focused on reducing manual process dependencies in loan origination, deposit pricing, and back-office reconciliation. Technology decisions should be made in the context of regulatory expectations, cybersecurity resilience, and total cost of ownership.

Navigating Complexity with Saltmarsh

In an environment defined by margin compression, shifting risk profiles, and ambiguous rate signals, the path forward requires more than patience: it demands precision. Community banks that proactively recalibrate ALM assumptions, validate credit risk models under new stress conditions, and align funding strategies with evolving depositor behavior will outperform peers still reacting to lagging indicators.

At Saltmarsh, our Financial Institutions team partners with community banks to strengthen the integrity of their risk frameworks and balance sheet strategy. Our ALM and risk model validation services are designed to help institutions anticipate and respond to volatility in the rate cycle, credit quality, and liquidity demands.

To learn more about our services and how we can support your bank in navigating this continued volatility, contact an advisor today.

 

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