ANALYSIS: Fed Survey Shows Banks Tightened Credit That Could Weigh on Economy

The U.S. Federal Reserve in Washington, in a file photo. Getty Images

News Analysis

Federal Open Market Committee (FOMC) staff economists have eliminated their recession forecasts, Fed Chair Jerome Powell confirmed at last month’s post-FOMC policy meeting press conference.

Over the past month, a chorus of economists and market analysts have reduced their recession odds, alluding to various data points—as well as Taylor Swift concerts—that prove a downturn is no longer a certainty.

Second-quarter gross domestic product (GDP) growth came in at a better-than-expected 2.4 percent, the labor market is still adding hundreds of thousands of jobs per month, inflation has slowed, and business and consumer optimism has improved. Meanwhile, the U.S. stock market has also been performing well, with the leading benchmark indexes deep into positive territory.

Can the good times last forever?

Many of the chief indicators are still flashing red, from the Conference Board’s Leading Economic Index (LEI) to the yield curve inversion in the U.S. Treasury market.

A more cautious banking system might also weigh on economic conditions, the rate-setting committee said in a statement last month.

“Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation,” the FOMC said in its July statement. “The extent of these effects remains uncertain.”

The Fed’s latest quarterly Senior Loan Officer Opinion Survey (SLOOS) suggests that financial institutions’ apprehension to lend could put pressure on the economy.

SLOOS and the Economy

U.S. banks are losing their lending appetite as economic uncertainty, regulatory fears, and deposit outflow concerns have resulted in tighter credit and weaker loan demand environment in the second quarter, according to the Fed’s second-quarter SLOOS report. However, the survey also highlighted that financial institutions anticipate further tightening of standards for the rest of the year.

Since March 2022, the central bank has raised interest rates by 525 basis points, and the SLOOS data show that banks have been responding to the rising-rate climate by reducing their lending. The banking turmoil from this past spring also has contributed to this trend in the financial sector.

The SLOOS report, published on July 31, collected responses from banks and confirmed tighter credit standards and weaker demand for commercial and industrial (C&I) loans to companies of all sizes in the April-to-June period. The same was seen for commercial real estate (CRE) loans.

Over the past three decades, there have only been two other times when lending was as tight: the 2008 global financial crisis and the 2020 pandemic crash.

Overall, the survey reported a net 50.8 percent of banks tightened credit terms in the previous quarter for C&I loans to medium- and large-sized businesses, up from 46 percent in the first-quarter survey. By comparison, it was 55.4 percent in the second quarter of 2008.

This figure was a bit lower for smaller firms at 49.2 percent, up from 46.7 percent in the prior survey.

Households also are bearing the brunt of a tighter credit market.

A "For Sale" sign is posted outside a home in San Anselmo, Calif., on March 22, 2023. Justin Sullivan/Getty Images

SLOOS figures revealed that lending standards tightened across residential real estate loans, home equity lines of credit, and nearly all consumer loan categories, except for credit cards.

“Overall, responses to the July 2022 and 2023 surveys indicate that banks’ lending standards have tightened since 2022 for all loan categories, including some that moved from being on the easier end of the range a year ago to being on the tighter end of the range in July 2023,” the report stated.

Economic uncertainty is a part of the reason for this development in the banking system.

“The most cited reasons for expecting to tighten lending standards were a less favorable or more uncertain economic outlook, an expected deterioration in collateral values, and an expected deterioration in credit quality of CRE (commercial real estate) and other loans,” the Fed stated in the report.

The SLOOS findings show that the consternation surrounding the economic outlook is expected to contribute to additional tightening of lending standards for the remainder of the year.

In addition to worries about the economy’s future, most banks say they will lessen their risk tolerance because of potential deterioration in liquidity positions, possible effects from accounting, legislative, and supervisory changes, and consequences of deposit outflows and funding costs.

Powell Offers a Preview

During his post-FOMC meeting press conference, Mr. Powell provided a bit of a preview of what to expect in the SLOOS report.

“It’s broadly consistent with what you would expect. You’ve got lending conditions tight and getting a little tighter, you’ve got weak demand, and you know, it gives a picture of a pretty tight credit conditions in the economy,” he told reporters. “I think it’s really hard to tease out whether how much of that is from this source or that source, but I think what matters is the overall picture is of tight and tightening lending conditions.”

Mr. Powell added that the ongoing tightening “will restrain economic growth,” although bank lending is “up significantly” from a year ago.

“It seems like the economy is weathering this well,” the Fed chairman said at the news conference. “Of course, we’re watching it carefully and expect to continue to do that.”

Minutes from the past several FOMC meetings showed that they were anticipating an economic downturn stemming from the fallout of the Silicon Valley Bank, Signature Bank, and First Republic failures. Instead, Mr. Powell noted, the central bank’s economists expect “a noticeable slowdown.”

“So the staff now has a noticeable slowdown in growth starting later this year in the forecast, but given the resilience of the economy recently, they are no longer forecasting a recession.”

The State of Banking

Since April 2022, deposits at all commercial banks have steadily declined, tumbling 5 percent to a low of $17.23 trillion, according to the Fed’s H.8 data. Deposits have been recovering at a modest pace, rising 0.6 percent since early May.

But small domestically chartered commercial banks haven’t recovered from the banking crisis earlier this year. Deposits remain about $200 billion below their pre-turmoil level, standing at roughly $5.2 trillion.

For months, U.S. officials have insisted that the banking system is safe, strong, sound, and resilient. Despite this reassurance, regulators from the Fed, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency issued a 1,000-page plan to tighten bank oversight extensively. It also includes a proposal to bolster large bank capital requirements.

In his semi-annual Monetary Policy Report to Congress and during the post-FOMC news conference last month, Mr. Powell voiced skepticism over Fed Vice Chair for Supervision Michael S. Barr’s proposal. He warned that there will be trade-offs involving slower economic growth and higher capital standards.

Federal Reserve Board Vice Chair for Supervision Michael S. Barr speaks during a Senate Banking Committee hearing in Washington on May 18, 2023. Anna Moneymaker/Getty Images

“U.S. and global regulators raised large bank capital requirements significantly in the wake of the global financial crisis,” Mr. Powell said. “While there could be benefits of still higher capital, as always, we must also consider the potential costs.”

However, Mr. Barr defended the proposal, saying that a bigger capital cushion “ensures that banks can continue to play their critical role serving households and businesses.”

“The goal of our actions today is simple: to increase the strength and resilience of the banking system by better aligning capital requirements with risk,” he said.

The public will have 120 days to offer feedback once the plan is formally published. Experts say that there will likely be intense pushback.

‘Hiking Us Into a Recession’

According to the CME FedWatch Tool, the futures market expects the Fed to pause on a rate increase next month. In November, there is a 33 percent chance of a rate increase; in December, there is a 30 percent chance of an increase in the benchmark fed funds rate.

The Summary of Economic Projections (SEP) in June revealed that policymakers anticipated two more rate boosts this year, with the median policy rate climbing to 5.6 percent.

“I would say it is certainly possible that we would raise funds again at the September meeting if the data warranted it,” Mr. Powell told reporters. “And I would also say it’s possible that we would choose to hold steady at that meeting.”

Ali Hassan, a portfolio manager at Thornburg Investment Management, is concerned that the central bank could “hike us into a recession.”

“I think September is still in play for a hike. Nothing has changed in terms of how the Fed balances the set of risks, and they want to see data confirmation,” Mr. Hassan said in a note. “The bottom line is I still fear the Fed will hike us into a recession, and the Fed appears comfortable with this risk.”

The FOMC will hold its next two-day policy meeting on Sept. 19 and 20.