Thinking About Interest Rates
In late August, Federal Reserve Chairman Jerome Powell announced that the central bank expected to keep interest rates at or near zero for the foreseeable future. That’s not really surprising. The U.S. economy has been in a recession since February, and this is hardly the time to consider a rate increase.
“We’re not thinking about raising rates,” Powell said. “We’re not even thinking about thinking about raising rates. What we’re thinking about is supporting the economy. We think this is going to take some time.”
Driving this significant policy shift is a change in how the Fed views the relationship between inflation and employment. Since 2012, the Fed’s goal has been to keep inflation at approximately 2%. Conventional dogma says the risk of inflation increases as the economy moves toward full employment because workers have more disposable income, which drives up prices — a concept known as the Phillips Curve. But this linkage has broken down in recent years, as the U.S. inflation rate has hardly budged above 2%, even when unemployment dropped to 3.5% in the fall of 2019. Powell says the Fed will still target a 2% inflation rate, but will give greater consideration to maximizing employment and worry less about a modest and temporary rise in inflation.
Fed policymaking sometimes seems like a lot of smoke and mirrors, so what does this mean for your bank?
For starters, it should be good news that the Fed is keeping rates low to aid the economic recovery. Banks can’t thrive unless the economy thrives.
And yet there’s no question that banks struggle to generate profits when rates are low because it limits how much they can charge for their loans. Most banks — including almost all community banks — are spread lenders, which means they live on the spread between their cost of funds and what they can charge for their loans.
The banking industry has been in this position before. After the financial crisis, the Fed kept rates at nearly zero for seven years before it gradually raised them again. But this time around seems different because of the Fed’s policy shift on inflation. The Fed began raising rates in 2015 when the economy had achieved a modest recovery, and unemployment had dropped to 5% from 9.9% in 2009. When the next recovery comes, the Fed may keep rates lower for longer.
For banks, this will require heightened emphasis on efficiency to maintain their profitability. A 50% efficiency ratio used to be the stretch goal for banks, but now it may be 35%. The effective use of technology will be paramount because that’s where many of the efficiency gains will come from. Technology can be expensive, so economies of scale will be critical. And the quickest way to generate economies of scale is through acquisitions.
This is what I think lies ahead: a more concentrated, more efficient industry that can go further on a gallon of gas — or in this case, a dollar of revenue.
