It's been a while since investors have dealt with inflationary pressures in the market. In October, the consumer price index (CPI), a measure of inflation on consumer goods, came in at 6.2% -- the largest year-over-year change seen since November 1990.
Jerome Powell, chairman of the Federal Reserve, recently said it was time to retire the word "transitory" when describing inflation. He also acknowledged that the "risk of higher inflation has increased" in his testimony to Congress last week.
One CEO who early on said inflationary pressures could persist was Jamie Dimon, head of JPMorgan Chase (JPM 1.21%). Dimon, who leads the largest bank in the U.S., said that inflation could rise quicker than expected and that this could pose a risk. Still, Dimon also said he isn't too concerned about it because of how the bank has prepared for the environment.
Dimon: "There may be a fat tail of inflation"
U.S. consumers have seen inflationary pressures come to fruition in 2021, with energy prices leading the way -- up 30% year over year. Other inflationary pressures have bubbled up due to supply chain disruptions. This year, semiconductor shortages have led to production disruption, which has hit new vehicle production hard. As a result, new and used vehicle prices have seen significant increases. Not only that, but real estate prices and rents have also seen a jump in prices.
Inflationary pressures have been at the forefront of many investors' minds for the better part of the year. Dimon said he has been keeping tabs on these inflationary pressures and determined that "there may be a fat tail of inflation." While Dimon isn't saying high inflation is a guarantee, he is saying there is a probability that inflation could "go higher than people think." He said that, as a result, the bank has positioned itself to deal with this risk.
How high inflation can hurt banks
When inflationary pressures persist, central banks tend to respond by raising the federal funds rate, which increases interest rates for all borrowers. Higher interest rates can be good for banks as it leads to higher net interest income. Net interest income is the difference between a bank's interest revenue from its assets and the interest expense it pays on its liabilities.
However, rising interest rates aren't always a good thing for banks. For example, if interest rates were to rise quicker than expected, JPMorgan Chase could see its net interest income decrease due to a misalignment of its short-term and long-term borrowings. That's because bank assets tend to be long-term focused while liabilities are shorter term. As a result, if short-term interest rates rose, funding costs would increase on those liabilities faster than interest earnings on assets, creating pressures on the bank's profit margins.
Not only that, but higher interest rates could lead to fewer originations on real estate loans and result in higher funding costs. Higher rates could also hurt borrowers with variable interest rate loans, or loans with rates that change as interest rates change. All of these could potentially hurt JPMorgan Chase's revenue, liquidity, and capital levels. So what is JPMorgan Chase doing to prepare for these inflationary pressures?
JPMorgan Chase is "hoarding cash"
JPMorgan Chase has been conservative about putting too much cash to work this year. Dimon has stated that being liquid can help the bank protect itself from higher inflation and higher interest rates that could come along with it. CFO Jeremy Barnum has said that the bank is "happy to be patient" in deploying this capital.
By hoarding cash, JPMorgan Chase sacrifices potential profits in 2021. The bank expects net interest income to come in around $52.5 billion for the full year, a drop of 3.7% from 2020. Not only that, but in the third quarter, the bank saw net interest income come in at a loss of $1.1 billion.
However, having extra cash gives the bank more flexibility in 2022 if inflation remains higher for longer than expected. The bank has nearly $600 billion in cash and cash-like assets that it can put to work if interest rates rise meaningfully in 2022 and beyond.
Jamie Dimon has done a stellar job of leading JPMorgan Chase, and his goal to make the bank "a port of safety" has him thinking about all risks to the business. While the bank is sacrificing short-term profits, its long-term foresight has it well-positioned if inflation sticks around.