The Federal Reserve is facing its first significant problem in the aftermath of a year of virtually unfettered path to higher interest rates. By raising the benchmark interest rate that banks use in lending money to each other, tighter monetary policy makes consumer and business loans more expensive and harder to get. In theory, that lowers demand for credit-financed goods and services, and in time also lowers inflation. Rising interest rates and a slowing economy are causing loan growth to fall, with the overall bank credit being stalled at about $17.5 trillion since January. Its year-over-year growth has been falling fast, and the Fed's next interest rate decision in May now hinges on whether policymakers decide that's just monetary policy running its course or something deeper. Household and business bank accounts remain comparatively flush, a buffer against too swift an economic comedown. Yet the potential for a worse-than-expected credit crunch remains elevated in the wake of the Silicon Valley Bank and Signature Bank collapses last month, which raised concerns of a larger financial panic. The worst seems to have been avoided as emergency steps by the Fed and Treasury Department protected depositors at both banks, helping ease what could have been a destabilizing run from smaller banks to larger ones. However, the cage was rattled as a year of rising interest rates had already put smaller banks under pressure, competing for deposits that were leaking into Treasury bonds and money market funds that paid more interest. The response - less lending, tighter credit standards, and higher interest on loans - was already taking shape.
The survey of large and small banks asks high-level questions - Are lending standards tighter or looser? Is loan demand increasing or decreasing? - yet is considered a reliable gauge of how lending will behave. It was already showing the wheels of a slowdown in motion. Results for the last quarter of 2022 showed a net share of around 45% of banks were tightening standards for commercial and industrial loans, the survey question seen as the best barometer for the direction of lending. Up sharply in the last three surveys, that is already near levels associated with recession. Some consumer loan standards were also getting stricter. Other banking survey data has also turned down. A Conference of State Bank Supervisors survey found the lowest sentiment among community bankers since the poll began in 2019. Nearly all of the 330 respondents, some 94%, said a recession had already begun.
Tighter credit is hitting an already-slowing economy, with key sectors showing stress. Small businesses are already reporting tightened profit margins, and it is difficult to gauge what this means for consumption, business investment, and inflation. Business investment and consumer spending make up the bulk of the economy, and credit tightening could lead to a recession. The Fed's next interest rate decision in May will be important in gauging the direction of the economy. If policymakers decide that it is just monetary policy running its course, then things will remain the same, but if they see something deeper, then interest rates may rise further, leading to a recession. Tightening credit is the mechanism through which that's going to impact the broader economy, so the Fed needs to be careful about its next move.
