April 18, 2011
I suppose the Fed would like to return to a normal rate environment. You know, the kind where one tug on the federal funds target rate corrects the course and snaps both price stability and maximum employment back in line. But the Fed’s preferred tool for directing the economy is a blunt instrument today. With the monetary supply so greatly expanded over the past three years, there is so much excess liquidity today that the economy would likely not respond to a higher target rate without some serious mopping up action first. For every extraordinary tool of monetary policy used to inject liquidity (think quantitative easing, among others), the Fed must eventually throw each in reverse to soak up that same cash. That is, if they want to sharpen and effectively use the target rate tool again. And that’s why Fed policymakers are talking.
Much has been made recently of the differing opinions of Fed Presidents and Governors. Although the March 15th FOMC meeting showed a unanimous vote for allowing QE2 to run its course and for maintaining the federal funds rate at 0 to ¼ percent, the minutes reveal a deeper debate has formed. Recent public comments by Philadelphia Fed President Charles Plosser and Minneapolis Fed President Narayana Kocherlakota suggest they are concerned about inflation and can see the Fed reversing course and tightening as the economy improves, while Fed Governor Elizabeth Duke and Fed Governor Daniel Tarullo have yet to be convinced that inflationary pressures are mounting and thus do not see the need to withdraw accommodative policies just yet.
If the debate seems more public than usual, it’s because airing these differences serves several important purposes. First, the Fed is waking us from our 27 month near-zero interest rate slumber, almost as if to say, “Now it’s getting interesting. I’d pay attention if I were you.” Secondly, the Fed is telling us that inflation is the key, and that policy makers will vote to curb inflation, when each is convinced that pricing pressures are not merely transitory. And lastly, the Fed needs us to believe that when it’s time to remove accommodation, that it is committed to returning to “normal” Fed tools of monetary policy, even if it takes years to wind down its extraordinary measures (and shrink its $2 trillion balance sheet). It’s fair at this point to ask, “So what does this mean to me?” As usual, the answer depends on your views and your business, with several examples explored below.
The liability-sensitive regional or community bank. Do you remember the Symposium on Interest Rate Risk Management that regulators held last year (January 2010)? It’s time to dust off the handouts and revisit their thesis. Recall that they were not saying that rates would rise soon, but rather that you should have effective tools in place to monitor, assess, and manage your IRR exposure. You probably heeded their advice, put your guard up, and watched rates like a hawk for awhile. And then, well, nothing happened. So while the regulators may not jointly and publicly ask you to do this again, they will nonetheless want to know that you are still vigilant and will not be harmed by rising rates. The public Fed policy debate gives you the cover to once again ask those tough questions and imagine how higher rates will affect your operations. Is it time to fix some of your floating rate wholesale funding? Maybe, maybe not. But it’s certainly time to revisit and ask the question, and develop the internal triggers that would have you act one way or the other.
The large US Corporate with international operations. Watching Fed policy makers debate is certainly not core to your business, but their message is for you as well. Borrowing costs won’t stay low forever. No, this does not mean you need to act immediately, especially since many corporates are flush with cash, but you do need to forecast future debt issuance or borrowings with the perspective that the Fed will eventually reverse course. To see how this will play out, you need look no further than the economies of your overseas operations. The European Central Bank raised rates in April to contain and control inflation, even as problems of unemployment and weak recovery persist in Greece, Spain, Portugal, Ireland, and others. And emerging market central bankers are stepping on the brakes with both feet to curb near double digit inflation in their overheating economies. If you borrow cheaply in the U.S. to fund overseas operations, you should know that Fed policy makers could just as easily be convinced of the need to address inflationary pressures right here at home. The public debate affords you the chance to gauge your own views and funding needs, and either lock in longer term funding now or determine the conditions under which you would do so in the future.
The real estate firm with floating rate debt. Swap, cap, or stay floating? How will you choose? After 27 months, even a business whose chief business risk is interest rates can be lulled into thinking that low rates are here to stay. And yet you know that just can’t be. Still, in managing your rate risk you may already have some large liability swaps on your books, remnants of the pre-crisis rate environment. Sure, with hindsight it would have been nice to stay floating, but remember what you did and why you did it. It’s because of the inherent uncertainty in the business, and our inability to know future rates. Which brings you to the current dilemma. The Fed policy debate is probably playing out right now in your own business. Just like the Fed has latched on to certain economic data to inform their decisions, it’s time for you to revisit the criteria that will help you choose your path. No one is saying rates will rise tomorrow, but everyone is saying that they will rise eventually. It’s time to make deliberate decisions again to fix or float, and understand your criteria for both.
If you have questions on what this policy debate means to your business, give us a call! While we can’t say when rates will rise, we can help you clarify your choices above the voices that differ on this matter.