Even as financial conditions have eased in recent months, helping to spur a rally in equity markets, one area of America’s real economy has been flashing warning signs: the commercial and industrial loan market.
The reduction in loan activity is a warning sign for middle market firms that, despite a resilient economy, they should proceed cautiously.
Demand for these loans, an important engine of growth, plunged last year as lending standards tightened, according to the Federal Reserve’s most recent quarterly survey of loan officers.
Reduced demand will result in less investment in productivity and, ultimately, slower growth this year. But that slower growth won’t show up right away because there is a lag period that we estimate to be about six months.
For middle market firms, this reduction is a warning sign that despite a resilient economy, they should proceed cautiously.
Other factors are at play as well. One is the mounting stand-off over raising the nation’s debt ceiling, which has already pushed up the cost of issuing debt. Additionally, the Federal Reserve recently emphasized its commitment to raising interest rates and keeping them there as it tries to cool demand and restore price stability.
For these reasons, we would urge firms to reaffirm and secure lines of credit and liquidity in case of a much more pronounced tightening in financial conditions.
The chance of a soft landing
Still, the recent robust hiring and more buoyant outlook in markets prompt a question: Does this latest upturn in financial conditions signal a soft landing for the economy and a quick return to normal business lending?
Economic slowdowns have historically been preceded by the tightening of lending standards like the one taking place. One reliable predictor of a slowdown, an inverted yield curve where long-term rates are lower than short-term rates, is in effect today.
But there are aspects of this business cycle that make comparisons to previous downturns and upturns difficult. For one, the pandemic prompted an unprecedented income-assistance program, followed by inflation and a demand shock that rivaled the end of World War II.
And with the labor market remaining tight, even after nearly a year of rate hikes, the Federal Reserve has little choice but to lift interest rates and hold them there as it tries to restore price stability.
For now, we can assume that the effect of the tight financial conditions last year will continue to affect business lending to some degree, dragging the economy lower while diminishing overall output.
The collapse of financial conditions last year because of the Fed’s response to the inflation shock was followed by a tightening of lending standards for large and middle market firms in the following two quarters.
Because of the increased perceived risk of default during periods of uncertainty, lenders demand additional compensation for holding commercial paper.
As such, the spread between commercial loans and the guaranteed return on Treasury securities would be expected to widen during economic downturns.
The tightening of lending standards and the increase in interest-rate spreads correspond to the plunge in demand for commercial and industrial loans by large and middle market firms in the fourth quarter.
Of note in the fourth quarter, banks reported tighter standards and weaker demand among all commercial real estate loan categories and tightening standards for construction and land-development loans.
The decline in demand and tightening of standards for commercial real estate lending seems reasonable, given the preference for working and shopping at home.
But the tightening of standards for the construction industry seems cautionary, particularly given the shortage of housing and the outsize role of rent of shelter in inflation calculations.