As the Fed forges ahead with higher interest rates, banks brace for a new normal

The Federal Reserve’s target federal funds rate is as high as it has been in a decade and is unlikely to go any lower for the foreseeable future, Chairman Jerome Powell said on Friday. But how this new reality will affect individual banks largely depends on the contents of their loan books.

During a speech at the Federal Reserve Bank of Kansas City Economic Symposium in Jackson Hole, Wyoming, Powell said he is waiting the rate should be just below 4% by the end of next year, a mark not seen since the start of 2008. He added that the Fed will not reverse the rate course until inflation will not have been firmly under control.

Jerome Powell, chairman of the US Federal Reserve, said on Friday that the central bank would do everything it could to curb runaway inflation. The implications of this new restrictive interest rate environment for banks largely depends on how they have managed their balance sheets.

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“Restoring price stability will likely require maintaining tight policy for some time,” he said. “The historical record strongly cautions against premature policy easing.”

Powell’s speech follows early signs of slowing inflation. Inflation data from July indicates that consumer prices remained stable taking into account the volatility of food and energy prices. The rhetoric reaffirms the Fed’s position that the nearly 15-year era of accommodative monetary policy is coming to an end.

Chris Maher, president and CEO of OceanFirst Bank in Toms River, New Jersey, said the paradigm shift was needed.

“Ultra-low rates are not normal and should not exist except in extreme crisis points,” Maher said. “Whether rates go up a bit, down a bit, or stay flat, we shouldn’t go back to that zero rate scenario. We’re entering a period that may probably be a lot more normal than what we’ve had.”

Maher said higher rates, at face value, should boost short-term banking activity. When the Fed funds rate is at its lower bound, as it was from March 2020 to March 2022, banks can borrow from the Fed at virtually no cost, giving them no incentive to take risks by granting loans.

“Commercial banks have this natural trade-off between the deposits they bring in and the high-quality assets and loans they put on their books,” Maher said. “In a zero rate world they have no value because you can borrow money at zero, so why do you need deposits and where is the great added value? Regardless of the neutral rate.. .you’re going to have a more traditional rate the slope and level of the yield curve.”

Peter Earle, an economist at the American Institute for Economic Research, said higher rates would lead to a return to a “classic balance” between higher profitability resulting from making more loans and higher related costs. at their service.

“It will be the classic way to increase profitability and increase the costs associated with those who fall through the cracks,” Earle said. “It’s in all areas but, in particular, you’re going to see it in car and motorcycle loans, and the kinds of areas that have challenged banks in the past.”

To take advantage of this new interest rate environment, banks must first be insulated from the implications inherited from the previous era. If banks have a preponderance of low-yielding, long-term assets on their balance sheets, this could make it difficult to fund new short-term liabilities. This is known as duration risk.

Komal Sri-Kumar, a senior fellow at the Milken Institute and an independent macroeconomic consultant, said this imbalance could ultimately hamper the ability of banks and other financial institutions to lend. If this happens on a large enough scale, he added, it could have ripple effects on the wider economy.

“To the extent that banks were not hedged on their long-term exposures, their longer-dated portfolios will yield less than they have to pay when borrowing short-term,” Sri-Kumar said. “It’s a risk for the institution. They’re going to cut their lending and that’s one of the factors causing a recession.”

Karen Petrou, managing partner at Federal Financial Analytics, said most banks are acutely aware of this risk and have taken steps to mitigate it, primarily by diversifying their mix of funding sources. But as rates continue to rise, further adjustments will likely become necessary, she said, noting that how those changes look will depend on a number of factors.

“As the cost of funds increases to the extent that it does, the composition of lending is going to change. Banks can start taking funds out of excess reserves and start putting them into the economy, and that would be very good for the economy and good for the banks, but that won’t happen in a recession,” Petrou said. “Loans can have a higher return, but they also come with a higher risk as demand declines. There are so many moving parts here. It’s quarter by quarter, bank by bank.”

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