Price Stability's Hidden Risk

By Harvey Rosenblum

History suggests that extremely low inflation can actually lower bank profitability, underscoring the need for vigilance in an era of stabilizing prices and falling rates.

Inflation is almost always portrayed in negative terms, but in one respect, it has proved beneficial to adroitly managed financial institutions in recent decades. Anticipating price increases, the market perennially required higher yields on longer-term loans and bonds, and financial intermediaries capitalized on the situation by borrowing cheaper short-term funds and investing long.

While it is true that an extreme application of this formula proved disastrous for traditional savings and loans, commercial banks generally have prospered from the inflation-driven difference between short-term and long-term rates, as evidenced by the comparatively generous net interest margins they have enjoyed in recent times. But what happens if the long-sought goal of price stability is finally reached in the United States and rate differentials substantially contract?

It has been 50 years since the last great era of price stability, and although the dynamics of the 1950s aren't strictly applicable to today, they do suggest that sustained flat prices are correlated with lower banking profitability, as reflected in net interest margins and returns on equity and assets. This has significant implications for bank management priorities.

In contrast with the last three decades, when interest payments comprised the single largest expense item for banks, a new era of price stability could reinstate the dynamics of the three decades before that, when employee compensation was the largest expense item. Banks that commit themselves to strategies that require employee growth, such as expansion of brick-and-mortar branch networks, could find it difficult to compete with organizations whose strategies are based on a shrinking employment base.

In any event, efforts to manage and control interest expenses will produce a smaller payoff as interest expenses become a smaller share of overall expenses. Conversely, efforts to control salary and benefit expenses will yield a bigger payoff as these expenses become a more important component of total expenses. In particular, the return on investment in labor-saving technology could increase significantly if the economy shifts to a price-stability paradigm.

This suggests that the outlook for prices and interest rates should be given increased significance in strategic discussions at financial institutions. No one can guarantee that price stability is just around the corner. But should it materialize, those banks that haven't thought through the implications of "price stability risk" will likely experience reduced profitability longer than necessary.

Falling Inflation Implies Falling Rates

One basic principle of finance is that investors must be compensated for the loss of purchasing power stemming from inflation over the life of their investment. In the long run, in other words, inflation expectations must be embodied in market interest rates. The higher the expected inflation, the higher the required interest rates, and vice versa.

Enter the Federal Reserve System. In addition to its legal mandate of taming inflation, the Fed also has a legal mandate to promote full employment. Though the Fed paid more attention to the latter directive through most of the 1970s, it has pursued the goal of price stability, some would say with a passion, since October 1979.

More than 23 years later, the price environment has been transformed. Inflation has plummeted from double-digit rates in the early 1980s to the 1% to 2% range last year. "If this isn't price stability, I don't know what is," said William McDonough, president of the New York Fed and vice chairman of the Federal Reserve's Open Market Committee, at a recent policy seminar hosted by the National Association for Business Economics.

The emergence of low inflation set the stage for lower interest rates, and the changes here also have been dramatic. From a high that exceeded 15% in 1982, the yield on the 10-year Treasury bond had dipped below 4% as we entered 2003. The transformed rate environment is important for bankers because, over the last four decades, the two single largest items on banking's profit-and-loss statement have been interest income and interest expense.

One clue to further improvements in price stability comes from the nation's business economists. As reflected in surveys by the NABE, these experts indicate that the high productivity growth enjoyed in recent years is here to stay, and that this will continue to put downward pressure on an already low rate of inflation.

The implication, again based on the principles of finance, is that there is room for interest rates to continue to adjust downward as the public becomes convinced that an era of price stability is upon us. Whether we actually enter a sustained period of price stability remains to be seen, however, and there would be a lag before that perception became embodied in the structure of interest rates.

But if we do shift from an environment where inflation is a constant in life to one where inflation is absent, what will it mean for the economy in general, and for the banking industry in particular? Price stability sounds great, but as the old Chinese saying goes: "Beware of the curse of getting everything you wish for."

As the Fed has carried out its mandate to provide our nation's citizens with price stability, it has not fully articulated what a steady-state environment would look like. The reason is simple: the last period of U.S. price stability occurred in the mid-1950s, nearly a half century ago. Most of today's policy and business leaders hardly remember what it was like.

Banking industry statistics do draw attention to the profitability question, however. In contrast with the late 1990s, when the collective net interest margin for U.S. commercial banks ranged between 3.5% and 3.9%, the overall net interest margin during the mid-1950s ranged between 2.1% and 2.7%. Similarly, the annual return on average assets during the late 1990s, ranging between 1.2% and 1.37%, towered over the 0.53% to 0.74% range recorded during the mid-1950s.

To be sure, a hypothetical new era of price stability would differ in many ways from the price stability of the 1950s. Deregulation and heightened competition have forced institutions to diversify their income sources, thereby reducing their dependency on interest spreads. And more than a decade's worth of consolidation and streamlining has better equipped the industry to translate revenues into earnings.

Nonetheless, banking profitability is still dependent on a benign-to-favorable interest rate environment. Banks that don't factor in the potential for that environment to shift markedly could find themselves having made long-term commitments that require large net interest margins for continued success.

Other Concerns

There are at least two other issues connected with this scenario, one pertaining to portfolio management and the other related to inflation's flipside, deflation.

As the economy edges closer to price stability, the structure of interest rates will continue to fall. The good news in the near term is that capital gains in bank investment portfolios will grow, thereby adding to profits as rates fall.

Institutions must guard against complacency, however, because interest rates will eventually cease to fall and capital gains will become nearly impossible to generate. Second, if the period of price stability ends with a return to rising inflation, interest rates will rise, thereby causing a sustained period of capital losses for institutions caught with unhedged positions in long-term fixed income investments. This would not be a happy ending to the story.

Unfortunately, the story could have an even worse ending. Disinflation, the process whereby inflation continues to fall (as it has been doing since the early 1980s) need not necessarily end with price stability. Instead, disinflation could morph into deflation, or a persistent decline in overall prices, similar to Japan's experience over the last decade.

Deflation was last experienced in the United States during the Great Depression of the 1930s. Nobody in banking, or in any other industry for that matter, wants to go there again. In an era of deflation, both prices and wages fall uncontrollably, the burden of debt repayment rises, and bankruptcies and defaults rise as incomes implode. Adding to the difficulty is the fact that stimulative monetary policy cannot help because interest rates cannot be driven below zero.

The Federal Reserve is well aware of these issues and understands the need to set a floor under the rate of inflation. Over the last two decades, the Fed's job has been to cap the inflation rate from above, setting lower caps each year. The dangers of overshooting the goal of price stability and falling into a deflationary trap are well understood.

The U.S. is on the brink of price stability, but we're not quite there yet. If we were, long-term, fixed mortgage rates would be around 4.5%, maybe lower, which is where mortgage rates were in the mid-1950s. But we are getting close. And as that day approaches, there's a strong chance that net interest margins will shrink significantly. Bank profitability would shrink commensurately until new sources of income are discovered.

For financial institution managers, the clear implication is that overall corporate strategies and asset/liability management strategies should be reviewed in light of the unfolding environment for prices and interest rates.

Mr. Rosenblum is senior vice president and director of research at the Federal Reserve Bank of Dallas. The views expressed are the author's and do not necessarily reflect those of either the Dallas Fed or the Federal Reserve System.

Copyright © 2003 by Banking Strategies, published by BAI.

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