Higher inflation is back. The questions now are how severe it can get and how long will that last.
“Inflation is running well above target and we expect it will continue to do so in the coming months ahead, before moderating as [supply] bottlenecks ease,” Federal Reserve Board Chairman Jerome Powell stated during a panel discussion of central bank heads held by the European Central Bank.
He added, when asked by Alessandra Galloni, Editor in Chief of Reuters, if central bankers had let the “inflation genie” out of the bottle, that even if supply-chain troubles ease, things will not go back to pre-Covid levels.
“We don’t mean prices will come down,” said Powell. “We mean that the inflationary spike will not lead to an ongoing regime of higher inflation. … The current inflation is the result of supply constraints meeting very strong demand.” Powell drove his fists together to emphasize the collision of the two forces.
One of the chief risks now is how the public and industry react to this inflationary ramp-up, he advised. “Will it start changing the way people think about inflation?” he asked. “We want to monitor that carefully.” Powell added that if substantial inflation beyond current levels began to return, beyond the board’s intended range, the Federal Open Market Committee, which directs Fed monetary policy operations, will use its full set of tools to hold things down.
Current surveys suggest a substantial amount of pessimism for the near term and medium term:
- For example, a survey of economists by Bankrate found that 37% believe that inflation is going to be higher than projected by monetary policy officials. Price increases caused by supply shortages and by rising wages being passed on to consumers and businesses may not go away, according to economists Bankrate interviewed.
- The New York Federal Reserve Bank’s Survey of Consumer Expectations, released in mid October 2021, revealed that people’s expectations for inflation in the short and medium terms has reached the highest levels since the study began in 2013. This reflects almost a year of increasing expectations marked in the survey.
So far the actual economic performance seen has justified the pessimism. In mid October 2021 the Labor Department announced that its Consumer-Price Index increased by 5.4% (unadjusted), which matched the increase seen in June and July of that year and pulled a bit ahead of August levels.
Change May Become the Only Economic Concept for a While
“It’s been interesting to see consumers’ behavior when all of the sudden we start showing up at our local restaurants, groceries and department stores and finding that everything costs 5% more, 10% more and 20% more,” says David Prager, Managing Director and Head of U.S. Restructuring at Kroll, LLC. “We’re just not used to thinking about the world in that way. And that’s going to lead to a shift in consumer spending that I’m not sure we’re fully equipped to predict at this point.”
Strange Days Indeed:
For most Americans, including bankers, business people and ordinary consumers, a return to significant inflation is a completely foreign concept.
The Covid period has already been marked by unusually high intervention by the Fed and by the Treasury Department. Powell noted that the coordinated operations of the two were parting again. However, Powell held out the possibility that more monetary policy moves could come.
“The historical record is thick with examples of underdoing it,” Powell said. “Pretty much in every cycle, we tend to underestimate the damage and underestimate the need for a response. I think we’ve avoided that this time.”
For a long time the Fed had been saying that inflation was “transitory.”
In a speech about inflation, Raphael Bostic, President and CEO of the Federal Reserve Bank of Atlanta, brought out a prop “swear jar.” He said he and his staff have to put a buck in the jar each time they use the word “transitory.”
He says a better word is “episodic.”
“It is becoming increasingly clear that the feature of this episode that has animated price pressures—mainly the intense and widespread supply chain disruptions—will not be brief. Data from multiple sources point to these lasting longer than most initially thought. By this definition, then, the forces are not transitory.”
— Raphael Bostic, Atlanta Federal Reserve Bank President
Bostic added: “It’s too early to proclaim we are witnessing a wage-price spiral like the one that led to the Great Inflation. But conditions merit watching.” (The Great Inflation refers to the period between 1965 and 1982.)
How JPMorgan Chase Is Thinking About Inflationary Risk
During the third quarter 2021 earnings call for JPMorgan Chase, the nation’s largest bank, in mid October, several analysts asked officials about inflation. Chairman and CEO Jamie Dimon struck a middle of the road tone.
Dimon noted that some of the healthy growth in the wake of Covid shutdowns has been amazing, given how things looked at the beginning. “We were facing virtually a Great Depression and a global pandemic and that’s all in the back mirror, which is good,” he said. Unemployment at 4% with jobs still open seems good too. “You can have good growth with some inflation and that’s okay.” Dimon said overall upward growth trends were more important than pricing at the individual customer level.
Will inflation start to ease again? Dimon suggested that bankers must be prepared in case that doesn’t happen.
“We prepare for probabilities and eventualities and one of the probabilities is [inflation] might go higher than people think and they will have to tamp it down.”
— Jamie Dimon, JPMorgan Chase
An analyst, Andrew Lim of Société Générale, observed that it seemed Dimon was taking “a benign view and that [inflation] was manageable and it’s not going to get out of hand.”
But Dimon disagreed.
“It’s the opposite,” he said. “I don’t know. We’re prepared for all eventualities. There may be a fat tail of inflation.”
Dimon has used that term in the past to describe out of the ordinary inflationary risk. He said JPMorgan Chase has been staying liquid as one response to the risks.
How Banks and Credit Unions Must Prepare for Inflation
In an interview with The Financial Brand, Kroll’s Prager noted that beyond the impact on consumers, business customers will be undergoing their own adjustments as more inflation kicks in.
“From a corporate perspective, while my costs are going up, my revenue line is not going to be able to go up because it will be constrained by a lack of consumer spending,” which will counterbalance price increases, Prager suggested. “And that’s going to be a vicious squeeze on a company that might otherwise be running on a narrow margin.”
Further compounding the challenges for businesses and for financial institutions is what Prager calls the “memory drain” issue. Inflation has not been a major issue since the early 1980s and the generation that went through that period is mostly gone now.
Time for Sharper Pencils:
Both businesses and the institutions that lend to them must start running analyses of their financials using much heavier “shocks” than are typically used.
For banking institutions specifically, addressing mismatches in interest rate risk now would be timely.
“If they find themselves upside down on their exposure to floating rates — where they are net borrowers at floating rates and lenders at fixed rates, they’re going to be in trouble if their interest rates rise along with inflation,” says Prager.
Now is the time to get the institution’s rate exposure in order, with all the implications that has for re-pricing and marketing at the new prices on both the asset and liability sides of institutions’ balance sheets. Prager suggests that a point can be reached where it is too late to protect the balance sheet.
Even with that, lenders must tread carefully. In a recent interview with The Financial Brand, Sam Sidhu, Vice Chairman, President and CEO at $19.6 billion-assets Customers Bancorp, said that he had been visiting with small business customers and that his read was that they are expecting high inflation.
Sidhu noted that inflation, in theory, can favor institutions that are asset sensitive. However, borrower health is critical, because a troubled customer can’t pay what they owe, no matter how good the lender’s numbers look on paper.
Meanwhile, in his speech, Atlanta Fed President Bostic gave a philosophical point to ponder:
“Anyone who doesn’t want to live in interesting times showed up in the wrong century. The Covid pandemic is the second tectonic (major) economic shock in these first 20 years of the 21st century — I’m counting the Great Recession as the first —and it may ultimately prove to be the most profound economic shock in our lifetimes.”