Can we all rise to the challenge of higher interest rates and inflation? Andrew Cunningham from our Faculty looks at how rising inflation is affecting economies and financial institutions. And he considers ways banks should respond to the consequences of inflationary pressures.
Shortly before the pandemic, I was teaching a course on bank risk to a group of students in their late 20s and early 30s. In the final session, I asked them to think about new risks and opportunities that banks might face over the next 25 years.
Of course, they identified fintech and open banking, climate change, and recognised that banks must be seen as good corporate citizens.
But none mentioned the possibility that the benign monetary environment, in which they had spent nearly all their lives, might come to an end. When I suggested they might see inflation and interest rates in double figures during their banking careers, they seemed incredulous.
It’s unlikely that a group of students would fail to mention interest rates and inflation as key risk – and perhaps opportunity – today!
Rising inflation around the world
On 5 May, the General Manager of the Bank for International Settlements, Agustín Carstens warned that, “We may be on the cusp of a new inflationary era.” He added “The forces behind inflation could persist for some time.”
In March, the US Federal Reserve raised its policy interest rate for the first time since 2018. US inflation in May was 6.8% – the highest in 40 years.
In May, the Bank of England’s Monetary Policy Committee predicted UK inflation would reach 10% by the end of the year. And it raised interest rates for the fourth time in six months.
In the EU, inflation is now running at around 7.5%. Policymakers have been signalling that the European Central Bank may raise rates in July – the first time in ten years – with further rate rises before the end of the year. This will bring to an end the curious era of negative EU interest rates that began in 2014.
Emerging markets are not exempt. Inflation in Brazil reached 12% in April, its highest level since 2003. In Egypt, India and Indonesia consumer prices are also rising and are at their highest levels for many years.
How does inflation affect the banks and financial institutions?
The most obvious trade-off banks need to manage is the increase in their net interest margins – enhancing the profitability of the basic business of intermediation – with higher non-performing loans, as customers struggle with the increased cost of loan repayments.
In many countries, companies borrowed heavily during the Covid pandemic. But they used the money to keep their business afloat, rather than fund expansion and growth.
At a retail level, consumers are under pressure from higher fuel bills and, in some cases, higher taxes as governments deal with deficits accumulated during the pandemic. In the UK, news stories about foodbanks, energy poverty and child poverty appear daily in newspapers.
Banks will be expected to play a role in alleviating the effects of higher living costs.
After being seen as the cause of the Global Financial Crisis and the resulting global recession, banks have emerged well from the Covid pandemic. They presented themselves as ‘part of the solution’ to a problem that was not of their making and enthusiastically participated in government support schemes.
With social responsibility – the ‘S’ in ESG – high on the agenda of financial policymakers and standard setters, banks should be careful about foreclosing on loans and withdrawing credit facilities.
Many banks have reported strong first quarter results for 2022. But they must have watched nervously as Shell’s announcement of record profits in May was swiftly followed by calls for a windfall tax.
How long will inflation last?
The era of low interest rates and low inflation is over. Gone are the days when inflation could be managed through a subtle nudge from a central bank monetary committee. There are bigger forces as play – the drawing in of supply chains, a war, and a lingering pandemic that continues to torment some major economies.
In his 5 May speech, Agustín Carstens noted, “A generation of society, workers and business managers who had never seen meaningful inflation – at least in advanced economies – are learning that rapid price rises are not merely the stuff of history books.”
Let us all hope that we can rise to the challenge.
Join us for our July webinar: The return of inflation.