US banks are eager for interest rate normality but, asks Brian Caplen, what are the risks of overshooting?

By most estimates the new chairman of the US Federal Reserve, Jay Powell, should have an easier time of it than his predecessors Ben Bernanke and Janet Yellen, who had to deal with the financial crisis and its immediate aftermath.

But unwinding the huge stock of treasuries on the Fed’s balance sheet at a time of unorthodox fiscal policy has the potential to derail. Interest rates may be forced up much faster than expected and in contrast to Ms Yellen’s gradualist approach. 

This would upset every investment and business calculation, from buying a house to corporate borrowing for growth. Banks need to factor this into their scenario planning to avoid being surprised by rapid movements in interest rates.

For most US banks the return of interest rates to something approaching normality is both overdue and highly welcome to prevent any further squeezes on net interest margins. But if they were asked to choose between rates staying where they are and a rapid increase, what would be their response?

In a letter to the Financial Times, professor Lars Oxelheim, of the Swedish Network for European Studies in Economics and Business, has gone as far as calling for the tapering to be put on hold until the US fiscal position is clearer.

To make his case he compares the Fed’s planned tapering activities in combination with Donald Trump’s expansionary fiscal policy to the situation in the 1980s. At that time, the money supply reductions of Paul Volcker together with Ronald Reagan’s tax reforms pushed interest rates above 20%. “With the bulk of investments today launched and evaluated at an extremely low interest rate, few investments will survive a double-digit percentage points rate increase,” writes Mr Oxelheim.

With this as a backdrop, the Jay Powell Fed term is going to require great skill to manage successfully and banks need to be prepared for various outcomes. 

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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