Guest Post: Some Thoughts On The Policy Bias Toward Inflation
Submitted by JM
Some Thoughts on the Policy Bias Toward Inflation
Banks fear deflation. They should: sustained deflation will most likely kill the banks. Also, since banks provide high-paying jobs to Federal Reserve types as kick-backs for well-aimed support while they are at the controls, the Federal Reserve fears it as well. As long as they keep banks going, they will be well-taken care once they are no longer with the Federal Reserve. Also, the only thing our current central banker in chief knows how to do to stimulate a basket-case is suppress nominal interest rates, or monetize debt.
I don’t really care much about the inflation/deflation debate much anymore, because to me it is aside from the point. What I care about is what the yield curve looks like because rates drive everything. Not much to chase away the gloom in this, just a way to think about stuff.
If you accept these curves, then a lender probably couldn’t care less about inflation either: steep yield curve, very high inflation, hyperinflation (CPI up 50% a month), none of it matters. This is because they can borrow at the short end of the yield curve lend farther out, and as a secured lender, they get recovery of the underlying asset in the event of default. The latter covenant is the most compelling reason in the world own banking stocks if (hyper) inflation is on your mind.
Consider that many risky ventures are financed with three to five year notes. The borrower may receiver a longer term amortization schedule to pay down principle more, but the bulk of the note will end up as a balloon payment at the end which will need to be rolled. In the very high inflation scenario, more cash flow will go into purchasing inputs, and if this input cost (programmer salaries, cost of fuel for travel) increase offsets the interest cost reduction, then a risky venture is worse off.
Now consider a risky venture that faced a giant balloon payment that they can’t possibly pay out of cash flow. A lender will offer refi terms based on market rates—rates that are expected to compensate for inflation. The business now has lost most if not all benefit from inflation-adjusted interest costs. It may be that the business prospects are so poor based on rising input costs and now interest burden that the terms will be adjusted for the risk, putting the business in a death-spiral. What recourse does the lender have in the event that this risky venture cannot afford to refi or make the balloon payment when the note term expires? The bank takes possession of the assets. They most likely are not experts in the venture, so they have tow choices: subsidize the venture for a while with better terms than the market requires just to keep it running, or they will have to sell the business whole or in parts to recover a fraction of their investment. Either way they lose a chunk, but they do not lose everything.
If a bank locks at least some funding needs in long term financing at a fixed rate, then banks will benefit from the erosion of this burden. At the same time, their costs of inputs (mainly capital) will rise much less than most business lines simply because they borrow at fed funds or some interbank lending rate like it. All they have to do is shorten their term risk.
If the yield curve ever did look like the hyperinflation scenario above, it is of course unsustainable and short lived. But there will be little capital left after it is over. Lenders will recover the real assets in the event of default, because there is no point in subsidizing a business that cannot possibly turn a profit. Then they will liquidate the asset to the highest bidder. Liquidation on a large scale will pretty much ensure that no business can turn a profit. A sustained yield curve like the one shown above will reduce all activity to only short-term activities and ones that increasingly reduce to barter type transactions. Nominal recovery may be higher, but there is not much they can do with the cash, other than move out of cash.
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