October 11, 2017
One of the primary reasons that Federal Reserve adjusts interest rates is to deal with inflation. When inflation is too high, the Fed might raise rates, and when deflation is an issue, they might cut rates. Unfortunately, this is sometimes too simplified as there are many factors at work in a complex economy.
Consider our current situation. Since December 2015, the Fed has raised the Federal Funds rate four times, with the current rate sitting at 1.25 percent. The Fed passed on another rate hike in September, but there is a good chance that we'll see another increase by the end of 2017. Despite the fact that inflation remains low, Fed Chair Janet Yellen believes that this is bound to change soon. Here is where we stand with inflation as well as how those changes will impact the U.S. banking industry.
Current inflation figures do not appear to be correlating with employment numbers.
What is Happening With Inflation?
The Federal Reserve sets an ideal inflation target figure of 2 percent annually. As of August, inflation was at 1.7 percent year over year. Historically, lower unemployment figures have correlated with faster rises in inflation. Again, as of August unemployment in this country was at a 16-year low and inflation appears to be slowing.
This lack of correlation is puzzling, even to Yellen, who has called it a "mystery" and questioned whether or not those labor figures are entirely accurate. Two potential issues come to light. It's possible that employment is not as strong as it appears, and that there could be other factors driving inflation.
On Sept. 29, the yield on the benchmark 10-year U.S. Treasury note hit 2.329 percent, which was the first quarterly gain of 2017. There was also a slight jump in consumer prices. Both indicators have led experts to declare that a long-awaited inflation boost is just around the corner.
How Inflation Impacts the Banking Industry
Banks typically deal in nominal financial instruments which makes inflation a key economic indicator for these institutions. These are instruments with fixed dollar amounts such as mortgages, securities, commercial paper, and notes. These instruments make up the bulk of bank assets and liabilities and the payments are fixed in terms of dollar value. Unless interest rates change in response to inflationary pressure, those assets will begin to lose value.
Inflation is often seen around periods of rising interest rates, and this impacts banks in several ways. Commercial borrowing demand may increase because companies are forced to spend more money to operate.
At the same time, the cost of doing business for banks increases, which will impact profit margins unless interest rates are hiked to compensate for these expenses. Finally, growth and consumer spending may increase as it no longer makes sense to hold onto cash that is losing value. On the other hand, consumers with loans may have difficulty making payments due to budget squeezes.
Healthy Inflation can have a positive impact on the U.S. banking industry.
Prepare for the Future with Garnet Capital Advisors
Inflation is likely on the horizon, which means that we will also see additional interest rate increases. In fact, the Fed-funds futures, which is an indicator of central-bank policy, shows a 78 percent chance of another rate increase this year. Banks should be looking to adjust balance sheets; adding high-quality short-term assets is a good move in this environment. Contact an experienced whole loan broker at Garnet Capital to learn how our loan sale advisory services can help your business.
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