Capital Finance

Eric Jordahl: Hospitals and health systems face risk as the Federal Reserve pursues normalization

November 30, 2021 3:54 pm
Eric Jordahl

Labor market concerns and growing inflationary pressures pose challenges that the Federal Reserve must address as the economy recovers from the COVID-19 pandemic. Healthcare organizations should be prepared for risk to their finances resulting from the Fed’s response to these challenges.

The Fed’s actions are of concern to hospitals and health systems because of the unprecedented level of influence it has established over the capital markets. As it confronts the potentially conflicting needs of confronting economic pressure points versus guiding markets to normalization, the Fed could very well end up undermining the critical role health systems’ balance sheets have played during the pandemic. Balance sheets have been the resiliency anchor, while operations have been the source of volatility. If market dislocations accompany pending Fed transitions, this dynamic could change.

The current state

As 2021 draws to a close, the Fed faces growing tension within its dual mandate to pursue both price stability and maximum employment. Established by Congress in 1978, the dual mandate puts the Fed in a more complicated position than most other central banks, which operate under a price-stability mandate only and therefore manage monetary policy with the undivided goal of stabilizing the purchasing power of their country’s currency. The addition of an employment mandate creates a potential conflict between owners of financial assets, who prioritize price stability, and those willing to tolerate higher inflation if it is a byproduct of the kind of economic growth that creates low unemployment, high labor participation, job flexibility and wage and benefit growth.

The Fed has always been an important force, but it began to assume its unprecedented level of influence over the capital markets by implementing quantitative easing as a response to the financial crisis of 2008.

Fed policy tools

Quantitative easing has joined the federal funds rate as one of two tools the Fed uses to implement its policy responses to issues affecting the markets. Here are brief descriptions of how these tools are used.

The federal funds rate. The federal funds rate is the rate at which banks and other depository institutions lend to each other on an overnight basis. Prior to the 2008 credit crisis, it was the primary lever the Fed used to influence rates and credit markets. By keeping this rate low, the Fed encourages the flow of liquidity throughout the financial system. Generally, expectations for low short-term rates will translate into relatively lower long-term rates. Without a program like quantitative easing, however, long-term rates are less influenced by the federal funds rate than by investors’ assessment of the risk that inflation will erode their real returns.

Quantitative easing. Under the quantitative easing approach, the Fed buys certain assets (Treasuries and mortgage-backed securities) with the goal of influencing liquidity and rates over the longer term. With a quantitative easing program, the Fed essentially commits the world’s largest balance sheet to effectively “cap” benchmark rates, with the expectation that all other fixed income markets will follow.

At the end of 2007, the Fed held roughly $891 billion of financial assets on its balance sheet. Following the credit crisis of 2008, these holdings increased to almost $4 trillion as the Fed aggressively purchased securities to try to facilitate market flows and create a favorable economic growth environment. Since the COVID-19 pandemic began, the Fed’s balance sheet has roughly doubled to more than $8 trillion as the Fed has used its buying power, paired with the federal funds rate, to maintain low absolute rates and a relatively flat yield curve.

A potential change in direction

Tensions within the dual mandate have heightened because, despite labor shortages driven by a lower labor force participation rate, the unemployment rate remains elevated above pre-pandemic levels (4.8% in September 2021 compared with 3.5% in February 2020, according to Bureau of Labor Statistics data released in October 2021).

Meanwhile, inflation has surged in 2021, climbing well above the Fed’s target rate of 2% inflation on an annual basis. The Fed’s policy used to be to get ahead of inflation, while its post-COVID-19 position has embraced the possibility of staying behind the curve (letting growth run), especially if the Fed thinks any inflationary pressures will prove transitory. The more inflationary pressures persist, however, the more difficult it will be for the Fed to avoid a change in direction.

The Fed has already signaled its intention to begin scaling back its quantitative easing program this year. Assuming it does so, the expected second step would be increasing the federal funds rate, potentially as early as 2022. Collectively, these actions would tighten liquidity flows and potentially cool the lending and other activities that provide the oxygen for both growth and inflation.

The risks of a new direction

Two significant risks lie ahead as the Fed tries to manage its way around the tension within its dual mandate.

First, if the Fed handles its tapering of the quantitative easing program poorly, the market could experience a sharp disruption like the 2013 “taper tantrum.” This kind of dislocation is unlikely and typically short term, but if it happens when an organization is trying to issue bonds, it can be very distressing.

Second, there is a longer-term structural risk associated with investors’ response to the Fed’s approach to quantitative easing and the federal funds rate. If investors are generally on board with the Fed’s plan, long rates may still trend higher, but financial markets — debt and equity — will likely remain orderly. If investors are skeptical, however, or believe the Fed is behind on managing inflation, then adverse market adjustments might increase in both pace and magnitude. If these dislocations are severe and sustained, then the idea of balance sheet as a resiliency anchor begins to erode.

4 steps for responding to the new normal

The best response to this reality involves four steps:

  1.  Develop a guiding point of view about the role of balance sheet resources in managing the organization.
  2.  Develop a point of view about the possible stress points on the path to stabilization across revenues, expenses, cash flow and balance sheet (debt and investments).
  3.  Identify and act upon opportunities to remove risk from the enterprise wherever doing so makes economic or strategic sense.
  4. Organize resources and develop a point of view on how to position them to drive resiliency and sustainable growth.

How to get to normalcy

Ultimately, an end to quantitative easing and a transition to higher interest rates mean that the economy and our capital markets are heading toward normalcy. The transition from here to there could be challenging, but a response grounded in corporate finance fundamentals — including great financial planning, dynamic risk management and disciplined resource allocation — will have the best chance of success. 

Unfamiliar territory: The Fed’s dual mandate and what comes next

The Fed’s responses to the financial crisis of 2008 and to COVID-19 have led us to a place we have never before experienced, with no defined road map back. Uncertainties range from the routine economic and market issues to the current political environment. There are already voices calling for the Fed to expand its focus beyond the dual mandate and become a more active agent in the pursuit of a wide range of policy goals. Different people will reach different conclusions about whether an expanded Fed role would be a good or bad development. But the important consideration is how this kind of transition impacts the Fed’s credibility, which it will need to manage to the next destination.

There was a time when markets were markets, and the Fed was the Fed. But today it seems more like the Fed is the market. It is a concentration of market power that comes in handy during times or major dislocation but may not be the best way for capital to be allocated over the long term. Whether this ever unwinds — and the extent of balance sheet disruption that organizations will have to endure along the way — remains to be seen. But organizations should prepare for a potentially choppy process as they seek to stabilize to a new normal.


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