Higher, longer: How bankers might approach today’s interest-rate environment

One major concern for bankers is the Federal Reserve’s interest-rate outlook, surpassing credit concerns and regulatory uncertainty. It would be wise to heed Chairman Jerome Powell’s advice and accept the reality of higher interest rates for an extended period, especially as stubborn inflation has persisted.

To address this, regulators are urging banks to improve liquidity and manage interest-rate risk.

Here are some steps bankers should consider:

1. Prioritize customer needs: Offer loan and deposit products that cater to customer demand. This approach will inevitably expose the bank to interest-rate risk, but it’s crucial to meet customer demands.
2. Mitigate interest-rate risk: Bankers should employ various strategies, such as pricing policies, investment decisions and wholesale funding transactions, to manage interest-rate risk effectively.
3. Learn from past mistakes: Banks that speculated on interest rates in the past, believing that inflation was transitory, faced significant challenges. It’s essential to avoid repeating such errors by considering a range of potential interest-rate scenarios and developing appropriate response plans.
4. Adopt a more comprehensive approach to analyzing interest-rate scenarios: Instead of just considering parallel changes in interest rates, banks should consider the relative likelihood of various interest-rate environments. This can be achieved by graphing current rates and the shape of the yield curve, as shown in the example below.

By implementing these measures, bankers can better navigate the current interest rate environment and mitigate potential risks.

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Of course, future rates may not meet market expectations.  Taking the historical perspective, zero interest rate policy (ZIRP) was the anomaly, not the norm.  The Fed Funds rate, the central bank’s primary policy tool, has often been in the 3%-7% range when the economy is doing well and inflation is under control. This is evident in the 1994-2000 and 2005-2007 periods shown below from the St. Louis Fed’s FRED charting tool (to say nothing of the 1960s and 1980s).

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Fed policymakers aim to maintain higher interest rates with enough maneuvering room during favorable economic conditions, allowing them to lower rates during downturns. Premature rate cuts, when the economy is close to full employment, could limit future policy options.

As market participants increasingly align with this perspective, the long end of the yield curve is beginning to rise, ultimately leading to long-term rates surpassing short-term rates.

In light of this possibility, it is vital for bankers to resist the urge to speculate on interest-rate movements. This approach has proven ineffective in the past and is not worth the risk now. Instead, bankers should focus on managing interest-rate risk, rather than attempting to predict the Fed’s rate adjustments.

Steven Patrick is Managing Director of Strategic Planning, Corporate Finance, Mortgage and Liquidity Management at Endurance Advisory Partners.