US Economy Faces Challenges from Tighter Lending Standards and Bank Instability

The US economy is facing headwinds from multiple fronts as tighter lending standards and an ongoing credit crunch are placing pressure on consumers and businesses. While fears of an impending recession have been fueled by the current economic conditions, Goldman Sachs chief economist Jan Hatzius believes that the situation will help the Federal Reserve fight inflation and cool the economy.

Tighter Lending Standards Impact on Credit Availability and Economic Growth

Tighter lending standards can lead to a credit crunch, making it difficult for consumers and businesses to access capital, which can have a dramatic effect on the economy. As banks reduce the number of loans they offer, it effectively cools down the economy. However, if lending standards become too tight or the Fed hikes rates too much, the economy can slow down to the point of sparking a recession. Banks raising interest rates faster than during any other period to quash inflation could also have the same inflation-fighting effect as rate hikes.

Bank Instability Adds Upward Pressure on Funding Costs and Endangers Credit Availability

Larger banks are more resilient in times of financial stress as they have higher capital and liquidity standards and are subject to more stringent stress tests from regulators. But recent bank instability is more like a “headwind” against economic growth than an outright recession-inducing “hurricane.” The potential for another bank run due to consumer wariness after SVB’s collapse is alarming, adding upward pressure on bank funding costs that could create greater downside risk to credit availability than statistical analysis suggests.

Federal Reserve’s Monetary Policy Stance Under Scrutiny as Inflation Rises

The Fed raised rates by 25 bps at its recent meeting and indicated that another hike was forthcoming. The bond market and the Fed disagree on future rate projections, with the market predicting a decline while the Fed predicting an increase in rates. The Fed sees inflation running hotter with projections for core PCE inflation rising, and the available data do not suggest an impending recession. While risk assets will likely be challenging to own in either scenario, as higher rates will constrain valuations and limit potential stock market gains or in the case of recession, significantly impact corporate earnings and depress stock prices.

Concerns over the Federal Reserve’s Ability to Manage the Economy

With inflation increasing at a fast pace, the Federal Reserve had to act to deal with the pain families were feeling as wage increases lagged behind the rise in the cost of living. In an effort to cool off the economy and get inflation to its target rate, the Federal Reserve began to increase the Fed funds rate rapidly throughout 2022. The latest CPI data reveals prices rose 6% in February 2023 compared with the same month the previous year–well above the new Fed funds target rate of 5%. The collapse of Silicon Valley Bank and Signature Bank complicates the Fed’s task of managing the macroeconomy by moving the Fed funds rate up and down to dampen inflation and boost economic activity when the economy eventually slides into a recession.

Unemployment Rates May Predict Next Recession

The truth of the matter is that a combination of fractional reserve banking, easy money, and FDIC depositor insurance has created a moral hazard that promotes risky bank lending. One of the best indicators of an impending recession is an inverted yield curve, particularly the difference between the 10-year Treasury note and the three-month T-bill. The Fed’s massive monetary stimulus of 2020 came home to roost in 2022 as we are witnessing increasing unemployment in financial sectors that benefitted from easy money policies since the Great Recession of 2008. When layoffs accelerate in areas such as hightech, a recession may be underway. If unemployment reaches politically intolerable levels, that’s when the Fed may be prompted to pivot and begin to lower the fed funds rate.

In conclusion, the US economy is facing multiple challenges that are impacting its growth trajectory. While tighter lending standards and bank instability are pressuring credit availability, the Federal Reserve’s monetary policy stance under scrutiny as inflation continues to rise. As we approach the end of 2023, we will need to watch for recession-inducing factors such as unemployment rates and yield curve inversions as well as potential changes in policy trajectory by the Federal Reserve.

Image Source: Wikimedia Commons