What happened

Shares of the major U.S. banks all were lower today after the Federal Reserve indicated yesterday that inflation might not be as temporary as some had initially thought. Shares of Bank of America (NYSE:BAC) fell more than 4% on Thursday, Wells Fargo (NYSE:WFC) closed roughly 6% lower, Citigroup (NYSE:C) dipped 3.7%, and JPMorgan Chase (NYSE:JPM) was more than 2.9% lower.

So what

The Federal Open Market Committee (FOMC) on Wednesday appeared to surprise the market, accelerating its timeline for when it expects to increase the federal funds rate, which influences most other rates and currently sits near zero.

While the FOMC left rates unchanged, as expected, it indicated that rate hikes could begin in 2023; previously, the FOMC had indicated that rates would stay near zero until 2024. The committee's dot plot that shows when individual members expect rates to rise suggested there will be two rate hikes in 2023.

Inflation has been a hot topic among investors, with many believing that rising consumer prices are a temporary result of excess stimulus dollars and a reopening of the economy.

Picture of wall with Bank of America logo and people walking by.

Image source: Bank of America.

But rate hikes typically occur when the economy runs too hot and serve as a tool to combat inflation, so the fact that the FOMC is pointing to rate hikes earlier than initially expected likely means the members see inflation being more of a long-term threat.

"This is not what the market expected," James McCann, deputy chief economist at Aberdeen Standard Investments, told CNBC. "The Fed is now signaling that rates will need to rise sooner and faster, with their forecast suggesting two hikes in 2023. This change in stance jars a little with the Fed's recent claims that the recent spike in inflation is temporary."

Now what

So how does all of this impact banks? Well, inflation can be both good and bad for them. When it triggers rate hikes, that's actually a positive because many of the interest rates that banks charge on loans move up and down with the federal funds rate, so when the federal funds rate rises, banks make a lot more net interest income on loans and securities.

Especially for Bank of America, Wells Fargo, and JPMorgan, a 1% rise in the federal funds rate would lead to billions of dollars more in net interest income, significantly boosting profits. On the other hand, runaway inflation can dry up demand and lead to a lack of spending and loan demand, which is a major way banks make money.

In my opinion, the market is overreacting here. Some smaller rate hikes sooner than later would benefit banks a lot because the economy is expected to boom over the next few years, so if banks could make loans at higher rates, their profits would surge.

Additionally, the banking sector has really done a good job of bringing in lower-cost deposits over the last year that will ideally stick better when rates rise. The other side of rising rates is that they push bank deposit costs higher, too, but hopefully the relationships banks have made over the past year will keep more of these deposits around and expand banks' profit margins.

Ultimately, while it's hard to know the final story with inflation, slightly higher rates would benefit all of these large banks.

 
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.