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The Wrong Way Bet
On May 3, the Federal Open Market Committee raised the federal funds rate another 25 basis points, to a target range of 5% to 5.25%.
Fed watchers believe this may be the last increase of this rate cycle as policymakers wait to see whether inflation is actually moderating. One promising sign is Wednesday’s report from the Bureau of Labor Statistics that the consumer price index rose 4.9% in April, compared to 9.1% last spring, and has declined from its peak in June 2022. But banks should not look past the rate plateau to a decline.
Interest rates have been on a relentless upward climb since March 2022; a pause in increases could give banks some much-needed breathing room and stability to address the rapidly shifting risk environment. The outlook for rates and the implications it could have on banks is a crucial conversation for boards and executives to have. Central to this conversation will be the bank’s long-term outlook for rates. What happens if they stay this high? What if they go lower? What if they go higher?
Banks will want to keep their eyes on drivers that might influence rate increases or decreases, like inflation readings and the Federal Reserve’s senior loan officers’ survey. Interestingly, the FOMC’s quarterly summary of economic projections in March indicate most participants believe 2023 will end with rates in a range of 4.9% to 5.6%. That is substantially higher than the probabilities in the futures market. The forward curve probabilities in the CME FedWatch Tool indicate that the fed funds rate will fall in 2023 and end in a range of 4.25% to 4.50%.
The difference in expected future rates is even more pronounced in 2024. Next year, FOMC participants see a wide range of rates, spanning between 3.4% and 5.6%. The probabilities in the futures market see rates hitting 2.75% to 3% by November 2024.
Given the gap between these two outlooks, bank boards may want to be skeptical about strategies that equate to an interest rate prediction, and instead focus on strengthening risk models and creating contingency plans for unexpected movements and changes.
As the industry has been powerfully and painfully reminded, loading up on long-term bonds in 2020 and 2021 that are now underwater was a bad idea. It has complicated bank liquidity profiles and could evolve into credit pressure. The last four quarters have underlined the risks of betting too much on the direction of rates, and the consequences of getting it wrong. Don’t double down now on rate predictions.
• Kiah Lau Haslett, managing editor of Bank Director
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