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Commentary
It’s Not Your Father’s Inflation
Outgoing Fed Chairman Greenspan has frequently telegraphed to the market his favorite measurement of inflation: the personal consumption expenditures (PCE) price index. The latest measurement came in at an annualized rate of 2.00%. That’s at the high end of the Fed’s advertised range of tolerance (1.50% to 2.00%). Unlike previous periods of inflation, characterized by wage and price pressures through the finished goods level, today such measures as the PCE price index are contained by high labor capacity and the readily available flow of capital from international sources.
Today’s case of "too much money chasing too few goods" has taken the form of asset inflation. One need not look any farther than the housing market or the pre-2000 technology equity markets. In the latter case, many would argue that Mr. Greenspan did not pre-emptively burst the tech stock bubble with overly restrictive monetary policy. Rather, once equity price erosion accelerated, the Fed employed an abundance of caution and opened the monetary spigots in order to contain the resulting economic malaise.
With the broad mandate of preserving wage and price stability, Mr. Greenspan’s discretionary powers have allowed the Fed to rapidly prescribe appropriate levels of monetary medicine. The next-at-bat, Ben Bernancke, is clearly on record as wanting to provide the markets with a quantified, desirable range for medium-to-long-term inflation. He firmly believes that a pre-defined inflationary objective would provide markets with a well-anchored expected-risk premium.
Back to asset price inflation, Mr. Bernancke discussed the subject at some length during an interview with the Federal Reserve Bank of Minneapolis in June 2004. In his comments, which were included in the June 2004 issue of The Region, The Federal Reserve Bank of Minneapolis banking and policy issues magazine, Bernancke cited several actions that central banks can use to defend against asset price dislocations above and beyond monetary policy. One of these he termed “micro-regulation.” Bernancke suggested that asset price increases have frequently been associated with regulatory gaps (e.g., corporate governance, accounting standards). Micro-regulation, a concept that could include government-mandated, credit underwriting standards, is viewed as a useful tool to counter the excessive credit booms that often precede asset bubbles.
The world in 2005 is vastly different than it was in 1987, when Mr. Greenspan took the helm. Whereas 18 years ago, a higher funds rate generally crowded out a finite supply of capital, resulting in a slowing of economic momentum, today’s yield-hungry global markets seem to reward Fed tightening by supplying still more capital, resulting in further escalating asset prices.
Conundrum is to Froth as a Steepening Yield Curve is to …?
With 18 years of congressional testimony under his belt, Mr. Greenspan’s embellished vocabulary may have spurred a slight increase in the test scores on the verbal portion of college entrance exams! The Chairman has frequently described the “conundrum” of long-term rates refusing to budge in the wake of tighter money supply, a low savings rate, skyrocketing current account deficits, and a “frothy” housing market.
As Figure 1 indicates, over the past month, yields across the curve have increased. During the month, the curve maintained its historically flat position, with the highest rate of increase taking place in the five-year sector. The spread between the two-year and the 10-year sector remains at approximately 20 basis points and has averaged approximately 62 basis points over the past year.
Figure 1. U.S. Treasury Yield Curve 10/7/05 vs. 11/7/05
Why no steepening in the wake of rising rates? During each of the past 10 quarters, the U.S. economy has grown in excess of 3%. That’s the longest winning streak since 1986.
One answer lies in the Labor Department’s latest reading on worker productivity for the third quarter. The relationship between hourly production and employment levels increased at a rate of 4.1%—the highest rate of increase in over a year and more than double the productivity levels reported for the previous two quarters. Furthermore, unit labor costs for the third quarter dropped by .5%, a sharp reversal from the 1.8% rate of increase during the second quarter. The combination of increasing productivity and reduced labor costs has helped to contain inflationary fears in recent trading sessions. Any future reversal in these trends, coupled with an end to the Fed’s ongoing tightening campaign, could prompt the yield curve to resume its positive slope.
Another Small Step
On October 18, Janet Yellen, president of the San Francisco Federal Reserve Bank, defined the rate at which overnight rates “neither spur or constrains” the economy, as being in the range of 3.50% and 5.50%. Not unexpectedly, on November 1, the fed funds target rate was increased to 4.00%—the twelfth consecutive increase. Forward rate markets are presently calling for a rate of approximately 4.50% within three months, and 4.75% within six months. The Fed’s posture will be closely watched following the January 31 – Feburary 1 meeting. There is a risk that further tightening under a new regime could be interpreted by the market as a sign of continued multiple increases. A softening rate of housing appreciation and more signs of a beleaguered consumer (consumer confidence is presently tracking a 15-year low) could also prompt a halt to further increases. Still, any spending shortfall from the consumer could readily be replaced by a cash-rich capital spending sector. Corporate cash is at record levels (cash holdings of S&P 500 index companies now exceed $2 trillion). As a result, corporate debt levels have room to increase, just as signs are appearing that consumer debt capacity may be waning.
Compressed Margins and Deposit Growth
For the second quarter of 2005, the FDIC noted that deposit growth for its insured institutions failed to keep up with loan growth. During the quarter, the industry’s annualized loan growth rate was 3.3%. The lead contributing loan categories were construction and development and C&I loans, with respective growth rates of 8.4% and 4.2%. With an annualized rate of deposit growth of 1.7%, the industry’s loan-to-deposit ratio has increased from 91.2% to 92.7%—the highest level since the first quarter of 2001. With continued yield curve flatness, interest margin compression has continued. In the case of institutions with assets in excess of $100 million, industry’s 3.49% interest margin represented its lowest level since 1990.
Figure 2. Historical Interest Margins – FDIC-Insured Banks
Source: FDIC Quarterly Banking Profile, June 2005
During times of margin compression, it’s hard to avoid the pitfall of ignoring the laws of marginal cost. Although it’s tempting to match your competitor’s deposit pricing, you may end up unnecessarily increasing rates on behalf of those customers who are not rate sensitive. Depending upon your cannibalization rate, in a rising-rate environment, it may make sense not to match your competitor’s deposit rates. Funding any deposit attrition via the Seattle Bank, as an example, may be far less expensive than raising rates on a deposit product. At this point in the rate cycle, at the margin, generating funds from your existing markets may exceed your cost of funding in the wholesale markets.
Another means of confronting margin compression is to consider the benefits of structured funding solutions. This month, we provide an example of a putable advance strategy that allows a financial institution to write an option and monetize it in the form of an interest rate that is below fixed-maturity levels.
John Biestman is assistant vice president, IMS consultative sales
advisor at the Federal Home Loan Bank of Seattle.
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