Key Points:
- US inflation has reached a 40-year high at 8.5%
- Covid-19 supply chain issues and the Russia-Ukraine war have caused energy prices to rise by 32%
- Food prices are also up 8.8% – the largest jump since 1981
- The US Federal Reserve has started a hiking cycle to curb inflation, raising the federal funds rate by 25 basis points and delivering a 50 basis point rate hike at the latest meeting
- Speculation is rife regarding further rate hikes and the impact on the economy
- Proper financial risk management is crucial during periods of inflation and rising interest rates
- Interpreting the Fed’s tone around rate hikes shouldn’t be the main focus; companies should focus on their own risk profile and employ proactive and reactive risk management measures
- Companies should carefully plan their current and future debt requirements and evaluate hedging strategies
- Choosing simple hedging instruments such as interest rate swaps and caps can help mitigate market risk
- Timing the market is impossible; firms should act based on pre-set objectives and risk tolerance
- Hedge accounting is important in reducing the volatility of financial statements
- Sound financial risk management planning cultivates a culture of risk management across the entire corporation
- CFA Institute members can earn professional learning credits by reading this article
US inflation has soared to a 40-year high of 8.5%, driven by COVID-19-related supply chain issues and the Russia–Ukraine war. Energy prices have risen a staggering 32% in the latest report, while food prices are up 8.8% – the largest jump since 1981. Many analysts are predicting a US recession as a result of these inflationary pressures.
In an attempt to curb inflation, the US Federal Reserve has started a hiking cycle, raising the federal funds rate by 25 basis points at the previous FOMC meeting and delivering a 50 basis point rate hike at the latest meeting on May 5th. The central bank’s aggressive actions reflect its concern about the evolving inflation outlook and the need to prevent runaway inflation.
However, speculation is rife regarding the intensity of further rate hikes and the potential impact on the economy. Some fear that multiple rate hikes this year could push the US into a recession, while others argue that aggressive rate hikes are necessary to combat inflation.
Amidst this uncertainty, proper financial risk management is crucial for companies and investors. It is important to protect against interest rate volatility and hedge floating debt. Companies should focus on their own risk profile rather than obsessing over market developments and the Fed’s tone on rate hikes. Leverage on the balance sheet can make it harder to absorb rate hikes and shocks, so proper risk management measures are necessary.
It is worth noting that relying solely on the Fed’s interest rate expectations can be risky, as unexpected events can frequently distort these expectations. Therefore, companies should carefully plan their current and future debt requirements and evaluate the tools available to implement their intended hedging strategies. The choice of hedging instrument is important, and sticking to simple instruments such as interest rate swaps and caps can help mitigate market risk.
While it is tempting to try and time the market, it is virtually impossible to do so. Firms should instead act based on pre-set objectives, risk tolerance, and a governance framework. Hedging policies provide guidance on factors such as interest rate environments and the flexibility of hedging instruments.
Hedge accounting is also important in reducing the volatility of financial statements. Appropriate application of hedge accounting standards helps mitigate the impact of repeated adjustments to the fair value of hedging instruments on the profit and loss statement. Matching the critical terms of the hedged item and its associated hedging instrument is crucial in successful designation.
Overall, sound financial risk management planning is essential in navigating periods of high volatility and uncertainty. It helps mitigate cognitive biases and ensures sustainability and endurance during challenging market conditions. It is important for boards of directors and executive teams to set a tone of risk management throughout the organization.
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