(Bloomberg) - Federal Reserve Bank of Minneapolis President Neel Kashkari said banks must be prepared for higher interest rates in case policymakers need to lift rates further to combat entrenched inflation.
Managing inflation and supporting financial stability, not usually in conflict, can pose a dilemma for policymakers if banks are unprepared, Kashkari wrote in an essay released Wednesday. While the banking system is currently “sound and resilient,” stresses could emerge again, Kashkari said, as they did in March when high inflation and rapid rate increases helped trigger the failure of several regional banks.
Markets currently expect inflation and interest rates to fall, in which case bank balance-sheet pressures would likely ebb, Kashkari said.
“However, if inflation proves to be more entrenched than expected, policy rates might need to go higher, which could further reduce asset prices, increasing pressure on banks,” he said. “In such a scenario, policymakers could be forced to choose between aggressively fighting inflation or supporting bank stability.”
The Fed held interest rates steady in June after raising them for 10 straight meetings to a range of 5% to 5.25%. Most policymakers expect to increase rates by a further half percentage point by the end of the year, according to projections released after their June gathering.
Kashkari’s prepared comments followed new data out Wednesday showing the consumer price index rose 3% last month from a year ago, and core inflation advanced 4.8%, the slowest pace since late 2021.
But the slowdown may not be enough to prevent additional policy tightening, with Fed officials widely expected to resume interest-rate increases later this month after pausing their rate hiking campaign in June.
“Increasing bank resilience now could minimize the risk that if high inflation is indeed persistent, tighter monetary policy would then trigger financial stability issues going forward,” he said. Because banks are unlikely to take steps toward greater resiliency on their own, supervisors should identify those at risk and see that they prepare.
Stress Tests
There are a few steps banks can take on their own to boost resiliency, Kashkari said, including raising equity, selling assets or restricting payouts to build capital. But banks are more likely to wait it out, on the expectation that inflation falls from here and the problem goes away, he said.
“Bank supervisors should use their existing authority to ensure all banks are prepared to withstand a higher-rate environment,” Kashkari wrote.
Supervisors could ensure banks’ preparedness with high-inflation stress tests to “identify at-risk banks and size individual capital shortfalls,” Kashkari said.
They could then direct those banks considered to be at risk of shortfalls to develop plans quickly, and could potentially restrict payouts. The new stress test combined with capital preservation plans would reassure the public and investors that the banks could handle a high inflation scenario, he said.
Fed Vice Chair for Supervision Michael Barr, who led the central bank’s internal probe of the failure of Silicon Valley Bank, has said the Fed’s annual stress tests should be rejiggered to better capture dangers that banks can face.
By Laura Curtis
