Banks and credit unions are on the verge of a period the likes of which almost nobody currently employed in those institutions has encountered in their working lives.
It’s the outlook for high inflation that has the potential to upend almost everything that today’s bank and credit union executives have come to regard as “normal.”
In the worst scenarios, the stage is being set for a period of high inflation that would be accompanied by much higher interest rates and potentially then by recession as governmental over-reaction slams the brakes on the economy. Experts indicate that this trend could be global, as the causes go far beyond U.S. borders.
A Key Definition:
Inflation is a complex subject. Simply stated, it is a time when too many dollars are chasing too few goods, raising prices at a pace that few working adults recall. The price of money typically rises too, in part due to market forces and in part as central banks attempt to tamp down inflation by rationing money.
Over time, multiple causes have triggered periods of inflation. The generation of financial executives that did business in the 1970s and early 1980s lived through what was described as “runaway inflation.” It was the time of the dreaded “wage/price spiral.” In 1979, new Fed Chairman Paul Volcker announced a draconian new policy of letting previously fixed interest rates float freely. It wreaked havoc especially with borrowers as rates rose higher and higher, but the policy eventually, painfully, helped tame inflation.
Banker Tracy Bacon, COO and previously CFO at FirstCapital Bank of Texas, remembers those days — though not as a banker. She entered banking in 1989, after college. But she was old enough to have a sense of what was going on in the household when her parents periodically discussed their mortgage rate, which was in double digits. At the same time, six-month CDs, one of the few savings vehicles not subject to now-extinct federal deposit interest rate controls of the day (Regulation Q), were likewise in double digits.
Though today’s mortgage rates remain quite low, Bacon is already having a taste of inflationary times. She moved to the Austin area recently and hopes to buy a home. However, she says, this has grown harder than it once was because prices have been driven up — sometimes doubling.
Bacon says FirstCapital management has been concerned about the return of inflation for some time, and has been developing strategies and cutting costs where they can.
Though the Fed and some economists believe the pain of the past can be avoided, other voices have much less confidence. Consider this from economists at Deutsche Bank in a report “Inflation: The Defining Macro Story of This Decade”:
“We worry that inflation will make a comeback. Few still remember how our societies and economies were threatened by high inflation 50 years ago. The most basic laws of economics, the ones that have stood the test of time over a millennium, have not been suspended.
— Deutsche Bank report
The report goes on to say that: “An explosive growth in debt financed largely by central banks is likely to lead to higher inflation. We worry that the painful lessons of an inflationary past are being ignored by central bankers, either because they really believe that this time is different, or they have bought into a new paradigm that low interest rates are here to stay, or they are protecting their institutions by not trying to hold back a political steam roller.”
Through interviews with experts and research, The Financial Brand presents a picture of what financial executives may find over the horizon. We’ll examine what seems to be leading to trouble and what it was like doing banking when inflation was last a major scourge. We’ll also look at some steps experts suggest taking.
What’s Bringing Back an Economic Shadow from the Past
If you ask Joshua Siegel what could bring on massive inflation, the banking expert reduces it to three words: “Too much money.”
Siegel has been surprised at the relative apathy he has encountered among bankers regarding the risk of high inflation and the likelihood of a return of high interest rates.
“Every banker I know is smarter than that, but somehow they seem to be willfully ignorant of the need to prepare,” says Siegel, Chairman and CEO at StoneCastle Partners, LLC.
Siegel notes that even before the Biden administration came in, the country had reached unprecedented levels of stimulus spending and accommodative policy and securities purchasing by the Federal Reserve. Even as the pandemic appears to be passing, a massive stimulus and infrastructure bill continues to percolate in Congress.
“And that’s why inflation risk is occurring,” says Siegel. “There’s too much money that’s been dumped into the economy. It doesn’t know where to go. And so it’s buying up Bitcoin, used cars, anything it can get its hands on because there’s no place to spend it.”
Concerning crypto, he adds: “It is honestly worth nothing. It is absolute air. But the fact that people would rather hold air than a fiat currency really should give us all pause.”
It’s generally been recognized that pent-up demand is driving up the prices of many things, but Siegel is talking about a much more fundamental, longer-term shift.
“You’re seeing monetary policy being dictated by populism. It’s ridiculous. ‘Give them cake’ — we’re just giving the masses what they want to hear, low interest rates,” says Siegel. “But this is not a demand problem. It’s a supply problem. And keeping rates low won’t fix that. Dropping rates to zero or negative ten isn’t going to make goods come out of India any faster.”
“The lack of fiscal responsibility from either major party is a dire matter, because you can’t just keep printing currency.”
— Joshua Siegel, StoneCastle Partners, LLC
Too much stimulus money wound up in savings deposits, and giving out more won’t help.
“It’s doing no good for anybody and the taxpayers paid for it by diluting what their dollars are worth,” says Siegel.
In time, he suggests, simple supply and demand and the reaction of other countries that have previously bought U.S. debt will lead to devaluation of U.S. currency.
“You could see a Honda Accord go from $25,000 to $250,000 once the dollar is worth 10% of what it was worth before,” says Siegel. “And that’s not a theory. Pick your favorite second- or third-world country. You can see it.”
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Inflation and Rate Increases Can Materialize Quickly
Siegel has tracked interest rates back to 1940 and found more than five occasions when interest rates ran up 500 basis points within 18 months, and one where rates rose by 1,100 basis points in two years.
The Deutsche Bank report states that “fiscal injections are ‘off the charts’ at the same time as the Fed’s modus operandi has shifted to tolerate higher inflation. Never before have we seen such coordinated expansionary fiscal and monetary policy. This will continue as output moves above potential. This is why this time is different for inflation.”
Putting Stimulus Into Perspective:
Deutsche Bank compares the recent fiscal stimulus to that caused by deficit spending the U.S. pursued to finance World War II.
Keith Leggett, formerly SVP and Senior Economist for ABA, says one of the dangers of inflation is that it takes on a life of its own in consumer thinking. “Once inflation takes hold,” says Leggett, “people adjust their behavior based on expectations of further inflation.” This leads to higher wage demands and to businesses raising prices, he explains.
When inflation begins to bear on an economy, Leggett continues, the Federal Reserve will respond with monetary policy tools. However, he adds, “monetary policy works with significant lags — almost a year.” The drawback to this is that it can take that long before it’s recognized what worked and what didn’t. In the meantime, the effort can make things worse.
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Politics and Ideology Aren’t Helping the Outlook
Also of concern is the perception that the Federal Reserve is being driven especially by politics right now.
“Unlike the early 1980s, when [President] Reagan supported the Volcker Fed’s putting the economy through a wringer to quell inflation, the problem is today viewed as much less important than unemployment and the broader goals of achieving greater equality in income and wealth,” states Deutsche Bank. The report points out that the impetus for more stimulus comes from a Democratic White House and Capitol Hill — and points out that Jerome Powell’s term as Fed Chairman runs out in February 2022.
Concerns about the impact of current policy moves are already being raised on Capitol Hill. Rep. Frank Lucas (R.-Okla.) told bankers at a House hearing that he recalls the turmoil of trying to get started as a farmer during the inflationary period of the 1970s and early 1980s. He was stretched tight with debt, and inflation drove interest rates way up — and many farmers out of business.
During a related Senate hearing, in response to questions about inflation from Sen. Mike Rounds (R.-S.D.), JPMorgan Chase’s Jamie Dimon said he expected 2021 to show economic strength that could last into 2023.
“But yes, it will raise inflation,” said Dimon. “I think there is nothing wrong with [a rate of] 1.6%. You know, I would expect it to go considerably higher than that. Hopefully it won’t be out of whack and the Federal Reserve will be able to tamp it down. But, you know, we always plan for things worse than that.”
Dimon also warned that the massive federal spending planned by the Biden administration could go wrong.
“If that money is wasted, is not productively spent,” said Dimon, “we will have more inflation, less productivity, slower growth, and the American democracy will have lost even more credibility in the world.”
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What Would High Inflation Look Like Today?
In June 2021 the Labor Department announced that consumer prices rose in May by 5% from the year earlier, which was the highest inflationary increase in 13 years. The more limited core-price index, which doesn’t cover food and energy, rose by 3.8%, the highest increase in 29 years. Some bank economists have suggested that such increases will level off as some new normality resumes after postponed spending works its way through the economy.
The inflation trend of decades ago had its roots in the 1960s with the demands of the Vietnam War and President Johnson’s “Great Society” programs, Leggett recalls. By the time Volcker arrived, the overall inflation rate had hit 9% (the Fed’s current target is 2%) and peaked at 11.6% in 1980. The Federal funds rate, the rate at which banks lend to each other, hit 20% in late 1980.
What would a period of high inflation look like? Leggett points out that the banking industry is better capitalized than it was going into the 2007-2008 Financial Crisis, so there will likely be less carnage in banking itself. But among financial institution customers, “inflation is going to cause some pain,” and efforts to curb it will cause more.
Siegel says that after the Fed steps in to cool inflation, real estate values will come down massively and defaults would rise, though for much different reasons than seen during the Financial Crisis. Depending on how severely inflation hurts the value of the dollar, there could be major impact on supply chains, which could result in the default of many commerce and industry borrowers facing rising costs for materials or shortages of materials. Borrowers with floating-rate debt would see their cost of loan servicing rise.
Leggett points out that once the Fed starts using rates to fight inflation, there will be serial increases. “It won’t be one and done.”
Ed O’Leary, now retired from commercial lending posts held over multiple decades, faced inflation both as a lender and as a loan committee chairman in multiple institutions. When inflation kicked in, he says, it had a way of changing the tenor of lender-borrower relationships. At the time institutions tended to restrict loans to “productive purposes,” he says, and a surge in inflation could turn a routine “yes” into a “no.”
For example, O’Leary says, take a loan to acquire an inventory of raw materials for manufacturing. A commercial borrower might simply be trying to secure adequate supplies in order to keep production going at their factories. However, under the right circumstances, a bank could determine that the borrower was as likely to be speculating on a price rise in commodities and seeking bank credit to finance that speculation.
As rates rise at lenders due to efforts to contain inflation, lenders become part of a rationing process that can leave some borrowers high and dry. At one point, O’Leary recalls, the prime rate was over 21%, versus 3.25% in June 2021.
“Those were hard days. During the Volcker period we were continually sparring with commercial borrowers over rates and purpose.”
— Edward O’Leary, veteran bank lender
On the other hand, O’Leary points out, it was during this time that a basic of today’s banking business solidified: asset-liability management.
What Can Banks and Credit Unions Do Now?
How the period ahead will shape up isn’t clear, but there are steps that can be taken to avoid being caught flat-footed.
Buy some rate insurance by paying up for fixed-rate deposits now. Presently many institutions are flush with deposits and it is easy to think that condition will last a long time. However, as the Deutsche Bank report suggests, savings accumulated during lockdowns and as stimulus checks were issued could quickly diminish. One scenario in the report has 25% of consumer savings flowing out over 18 months.
Siegel suggests attracting term deposits by paying up now and locking in funding in preparation for a major rise in rates. This won’t solve everything, but it is a cheap hedge in the long-run, he says. Purchasing interest-rate caps can also help. While they aren’t a complete protection, they can help in the case of “extreme tailwinds,” in Siegel’s words, “and those are the ones that hurt.”
Warning for Smaller Banks and Credit Unions:
Federal liquidity rules will keep large institutions, with deeper pockets, interested in raising retail deposits, which underscores the importance of locking up funding now.
Promote variable-rate loans now. This is the time to market variable-rate credit cards, consumer loans and business loans, says Leggett, to avoid getting caught underwater as the rates on liabilities climb.
Banker Tracy Bacon says that FirstCapital, which is predominantly a commercial lender, has already shortened the maturity of business loans that it will make at fixed rates to two-to-three years, versus five. Much of the portfolio is already tied to prime, at floating rates.
Lenders will have to consider the impact of increases in floating rates on borrowers of all types. A variable rate may protect a lender’s asset-liability management position. But if the borrower can’t afford the payments then they become a credit problem.