Itay Goldstein
One of the worrying developments of late time is the rise of inflation. Consumer prices in the US have soared since April, recording annual inflation rates of 5.4% in June and July. Such rates have not been seen for well over a decade.
There are several factors behind the rise in inflation, one of which is the imbalance between supply and demand. Pent-up demand for various products and services in the first half of the year, combined with supply shortages due to supply chain interruptions — both Covid-related and non-Covid related — have led to price increases. These are the basic rules of supply and demand at work. Another factor is the massive stimulus, both monetary and fiscal, injected by the US government into the economy. The effects of these events on prices were also to be expected, according to basic economic theory.
The net effect will be different across banks depending on their structure of assets and liabilities
The hope, constantly voiced by the Federal Reserve with a great level of confidence, is that this spike in inflation is temporary and reflects the unusual economic adjustments resulting from the evolving pandemic. The thinking is that supply and demand imbalances will subside as things return to a steady state, and that the stimulus was necessary to keep the economy afloat during the pandemic and will not have a long-term impact.
While this line of thinking has merit — and there are encouraging signs that inflation is indeed transitory — future developments with inflation are much more uncertain. If consumers, employees and firms expect future inflation, then inflation is difficult to stop. If employees demand wage rises because of increasing prices, companies will continue to raise prices, which leads to more wage rises and so on. This is where inflation becomes a self-fulfilling expectation and could get out of control.
Inflation in the US has been mostly under control since the early 1980s. The experience of the 1970s was so powerful that policy-makers have been inclined to be very cautious. The crisis of 2008 presented a challenge, and when the large stimulus did not lead to inflation, the thinking started to shift and inflation started to look more like a ghost of the past. But the dynamics now are different and the conditions are such that inflation might develop. This is a risk that cannot be ignored.
The impact on banks
Among the many effects of inflation on the economy, the impact on banks is particularly noteworthy. As chief financial intermediaries between lenders and borrowers, they could see various exposures: some are more expected than others; some are more material than others.
Inflation could be good for banks, some might argue. In recent years, the low interest rate environment has hurt banks’ profit margins, making it more difficult for them to provide adequate returns for their investors. An increase in inflation, leading to an environment with higher rates, could relax these constraints and allow banks to turn higher profits.
A more negative view, however, is based on a different channel. A key feature in banks’ business models is maturity transformation — banks tend to hold long-term assets and short-term liabilities. As such, high inflation and rising rates might hurt their balance sheets, reducing their profitability and threatening stability.
Banks will also be affected through other channels, as inflation will affect the real economy and the ability of borrowers to pay back their loans; it will affect financial markets and the returns that banks achieve on their investments in securities. On balance, the net effect will be different across banks depending on their structure of assets and liabilities, who their main borrowers are (large firms, small businesses or households) and the mix of their securities holdings. To be prepared, banks should therefore analyse various inflation scenarios, how they are exposed to them and what the implications might be for their financial ratios.
Stress tests provide a good framework for this kind of exercise. Stress tests emerged in the wake of the 2008 financial crisis as a risk management tool for banks and their supervisors. As current financial ratios do not reflect the resilience of banks under different scenarios, and because it is difficult to predict what conditions will look like in the future, stress tests emerged as a tool to inspect banks’ financial resilience under extreme adverse scenarios. They have been conducted since then in the US by both the banks themselves and by the Federal Reserve.
Coming up with the appropriate adverse scenarios has always been an important challenge with the stress-testing exercise. It is difficult to predict what might happen and it is easier to resort to extreme events from the recent past as a guide. In the current environment, with looming inflation risks and no such guide on what they might entail, it will be particularly important to think outside the box. Banks and regulators also need to look at a high inflation scenario, and how it might affect profits and balance sheets through all the various channels.
Itay Goldstein is professor of finance at the Wharton School of the University of Pennsylvania.
