The Federal Reserve recently
As the CEO of an advisory firm that works with many community banks, I am stunned at the disparity between the Fed’s hypothetical scenario and what is happening in the economy right now. The Fed has prescribed a scenario that is just like another 2008 financial crisis. It assumes gross domestic product collapses at a similar rate; the unemployment rate rises to a similar peak; housing and commercial real estate prices decline by a similar rate.
But that is not the shocking part. It’s what the Fed assumes about interest rates.
CCAR 2022 assumes declining interest rates because, of course, this is what the Fed does when combating a recession. However, this is the complete opposite of our current economic environment.
We have an inflation problem, and the Fed is under pressure it hasn’t seen in over 40 years to increase interest rates to deal with it. The worst-case scenario is one in which the Fed must increase interest rates much higher than expected to stop inflation, even if it means putting the economy into a recession. This is the “Sophie’s Choice” that Paul Volcker faced as Federal Reserve chairman in the early 1980s.
This is often referred to as a “stagflation” scenario. Volker increased interest rates as high as 20% while the unemployment rate was hovering around 10%. We don’t need to go anywhere near that now to trigger such damage. Can you imagine what the economy would look like if the federal funds rate were even at 5%?
I am not predicting stagflation as a base-case scenario. But if we want to have a serious talk about a tail-risk event that is a function of the current economic climate, a stagflation scenario must be at the top of the list. Geopolitical triggers such as the Russia-Ukraine war will only exacerbate supply-side issues and ramp up pressure on energy prices.
What happened in 2008 was completely different. Inflation was not a concern. The Fed had plenty of room to bring down interest rates.
The largest banks must follow the CCAR 2022 scenarios. But I think they would be smart to also run a stagflation scenario. And it’s not to make regulators happy. This is smart and responsible risk management.
Community and regional banks should also think about stagflation as a tail-risk scenario. Variable-rate loans will behave differently than fixed-rate ones. Cost of funds will increase and there will be a fight for deposits (again). Capitalization rates and capitalization rate spreads will change the value of real estate collateral supporting loans. Fee income streams will dry up. This would be quite different from a 2008-style downturn.
There is always at least one smart director on every board who will ask, “Why aren’t we running this scenario?” Don’t be that CEO without a good answer.
