Inflation has the greatest impact on the value of fixed-rate debt securities since it devalues both interest rate payments and principal repayments. After correcting for inflation, lenders lose money if the inflation rate exceeds the interest rate. This is why investors sometimes look at the real interest rate, which is calculated by subtracting the nominal interest rate from the inflation rate.
Do bank stocks fare well in the face of inflation?
Due to supply-side interruptions and bottlenecks caused by the epidemic, labor shortages, and exceptional demand for goods and services following the lifting of lockdowns, prices have been moving higher. Now, a recent increase in daily Covid-19 infections in the United States to around 760,000 in the previous week, owing to the emergence of the highly infectious omicron virus type, might further disrupt supply, pushing inflation higher. That said, it’s already a foregone conclusion that the Federal Reserve will proceed with its plans to raise interest rates multiple times this year, with the first boost expected in March.
While stocks often outperform bonds during periods of high inflation, our Inflation Stocks theme includes companies in the banking, insurance, consumer staples, and energy sectors that may gain more from high inflation and potentially higher interest rates. Over the course of 2022, the theme has returned a healthy 6%, compared to a -2 percent drop in the S&P 500. Over the course of 2021, the theme returned around 21%, underperforming the S&P 500, which returned about 27%. Exxon Mobil has been the best performer in our subject, gaining by 49 percent in the last 12 months. Citigroup, on the other hand, has been the worst performer over the last year, with its shares maintaining nearly flat.
What happens to banks when prices rise?
They lose because they are net monetary creditors. However, they benefit as demand deposit issuers. The second effect may easily outweigh the first with more indexing and more accurate forecasting of future inflation.
Bankers have recently learned to recognize and manage interest rate risk. Bankers learned of the need to hedge their balance sheets against this risk by applying duration analysis, thanks in large part to the efforts of the editor of this journal in a series of articles in American Banker. The duration of equity (a value-weighted average of the durations of assets and liabilities) was set to zero to protect the bank from interest rate risk. With this position, the bank was considered to be immune to modest changes in interest rates. However, this immunization technique only safeguarded the bank’s nominal market value, not its real market value that is, the bank’s market value in today’s dollars, not the bank’s market value in inflation-adjusted dollars. This post aims to start a conversation on how to correct this oversight.
Do banks profit or lose money as a result of inflation? Is it the rate of inflation or the rate of change that matters? Is the impact of pricing changes symmetric? Is it true that disinflation has the same but opposite effects as inflation? What role do expectations play in the process? Is it possible for banks to avoid these consequences?
We’re mostly interested in the impact of shifting prices on net interest income and capital values here. The impact of inflation on noninterest revenue and expenses, as well as the real resource production function of banks, will be discussed in future articles. This latter assumption equates to the plausible (but controversial) belief that actual (inflation-adjusted) noninterest revenue and expense are unrelated to price changes for the purposes of this article.
The focus is on how inflation affects banks, rather than how banks have been affected by specific inflations. As a result, we exclude factors such as increased bank competition and regulatory changes (both of which have a significant impact on bank earnings), as these are not always caused by inflation.
We start by going over the economic literature and the basic “overview” ideas. We then show how both theories are subsets of a broader approach whose major components are rates of change in expectations and portfolio adjustment speeds. The more comprehensive hypothesis serves as a foundation for future research.
In the economics and finance literature, the impact of inflation on actual bank earnings has been extensively explored. There are two competing and opposing models. Banks, according to Alchian and Kessel (A-K), are net monetary creditors (i.e., their nominal assets are greater than nominal liabilities). As a result, rising prices would reduce the value of their nominal assets more than their nominal liabilities. As a result, banks will lose money during an inflationary period.
The inflation tax school, on the other hand, argues that because banks’ demand deposits account for a component of the money supply, they should be able to capture a piece of the inflation tax and so profit during an inflation….
Are banks a smart way to protect against inflation?
Inflation isn’t necessarily a bad thing for everyone. When prices rise, some firms fare better. As interest rates rise, banks normally make more money because they may benefit from a bigger margin between what they charge for loans and what they pay out for deposits. During inflationary periods, companies with low capital requirements and the potential to raise prices are frequently the best positioned. These companies can keep and grow their profits without needing to reinvest significant sums of money at ever-increasing prices.
Warren Buffett, the legendary investor, famously claimed that in an inflationary environment, an unregulated toll bridge would be his favorite thing to own since you would have already built the bridge and could raise charges to combat inflation. “If you build the bridge in old dollars, you won’t have to replace it as often,” he explained.
Where should I place my money to account for inflation?
“While cash isn’t a growth asset, it will typically stay up with inflation in nominal terms if inflation is accompanied by rising short-term interest rates,” she continues.
CFP and founder of Dare to Dream Financial Planning Anna N’Jie-Konte agrees. With the epidemic demonstrating how volatile the economy can be, N’Jie-Konte advises maintaining some money in a high-yield savings account, money market account, or CD at all times.
“Having too much wealth is an underappreciated risk to one’s financial well-being,” she adds. N’Jie-Konte advises single-income households to lay up six to nine months of cash, and two-income households to set aside six months of cash.
Lassus recommends that you keep your short-term CDs until we have a better idea of what longer-term inflation might look like.
What are the ways that banks profit from inflation?
- Inflation is defined as an increase in the price of goods and services that results in a decrease in the buying power of money.
- Depending on the conditions, inflation might benefit both borrowers and lenders.
- Prices can be directly affected by the money supply; prices may rise as the money supply rises, assuming no change in economic activity.
- Borrowers gain from inflation because they may repay lenders with money that is worth less than it was when they borrowed it.
- When prices rise as a result of inflation, demand for borrowing rises, resulting in higher interest rates, which benefit lenders.
Why are banks so afraid of inflation?
When the rate of inflation differs from expectations, the amount of interest repaid or earned differs from what they expected. Unexpected inflation hurts lenders since the money they are paid back has less purchasing power than the money they lent out.
In a recession, what happens to bank stocks?
Stock prices usually plunge during a recession. The stock market may be extremely volatile, with share prices swinging dramatically. Investors respond rapidly to any hint of good or negative news, and the flight to safety can force some investors to withdraw their funds entirely from the stock market.
Why are banks so opposed to inflation?
Even if the economy is sluggish and inflationary pressures appear faraway, David Leonhardt explains why the Fed is so hawkish on inflation:
Why is the Fed more hawkish than the rest of the economics profession? Part of the explanation rests in how the policy-making committee’s 12 voting members are picked. They are a mix of presidential appointees who must be confirmed by the Senate and serve 14-year terms, as well as regional Fed presidents who are chosen by independent boards that include private-sector financial leaders.
Banks frequently have more to lose from inflation than from unemployment, according to David Levey, a former managing director at Moody’s and another critic of the Fed’s passivity. Inflation lowers the future worth of the money owed to them by their borrowers, such as homeowners, automobile buyers, small businesses, and others.
“Mr. Levey claims that the Fed regional banks “reflect, in essence, the financial community, which is conservative and hawkish.” “Inflation irritates creditors, but it benefits borrowers.” Regional bank presidents Richard W. Fisher of Dallas, Narayana R. Kocherlakota of Minneapolis, and Charles I. Plosser of Philadelphia were among the three recent dissenters.
This is, without a doubt, the traditional viewpoint, and it was true at one time. Is this, however, still the case? Or, perhaps, my actual question is whether it should still be true. Isn’t most long-term debt either indexed to inflation or insured against inflation risks in some way (typically via linkages to LIBOR or treasury spreads or something similar)? Shouldn’t banks now days be unconcerned about inflation as long as it stays within a reasonable range? I’m sure there’s a flaw in my grasp of finance here, but I’m not sure why the creditor/debtor division on inflation still remains.