Another Reason a Quick End to the Fed’s Rate Hikes Looks Likely

In the November 25, 2022 edition of Barron’s, Randall Forsyth penned an article entitled “Another Reason a Quick End to the Fed’s Rate Hikes Looks Unlikely (emphasis added). One of the reasons Forsyth advanced for his forecast (?) of future Federal Reserve interest-rate policy is the behavior of commercial bank credit. “…Joseph Carson, former chief economist at AllianceBernstein, points out that bank credit growth is booming. Loans to businesses and consumers, and for real estate, are accelerating at the fastest pace since 2008, he writes in his blog on LinkedIn.” Earlier in his article, Forsyth says “… [g]rowth in the M2 [money] measure, which consists of currency, checking, and other transaction and retail savings accounts, has collapsed to about 2% below the level a year ago. That’s a stunning reversal from the explosion in the money supply from pandemic monetary and fiscal stimulus; year-over-year, M2 expansion peaked at 27% in early 2021.” Forsyth goes on “… the contrast between the sharp slowing in M2 (which went negative, on a month-to-month basis, in September and October) and strong expansion in credit is puzzling. What should be done about this?” Earlier in the Forsyth article he cites Nancy Lazar, the veteran economist who heads macro research at Piper Sandler, “… [t]he slowing in money growth is the good news. The bad news is that M2, at $21.4 trillion, is still very elevated, by about $4 trillion over where she estimates it would be had it stayed on its prepandemic growth track.” This implies that the private sector has a lot of cash in reserve to fund spending even if the rate of growth in cash has slowed. Veteran economist and former chief economist at The Northern Trust Company, yours truly, discussed the implications of the large amount of cash held by the nonbank private sector in two commentaries, “Households’ Extraordinary Cash Holdings Will Thwart Fed Tightening” (March 14, 2022, LinkedIn, or “Viewpoints” section of Haver.com)) and “Households, Corporations and Banks Are in Good Shape as Recession Looms” (October 17, 2022, LinkedIn or “Viewpoints” section of Haver.com). If the nonbank private sector is now so flush with low/no-yielding M2 balances, why are they borrowing from banks at elevated loan rates? Is that a sign of private sector strength?

Let’s do some fact checking before arguing that there is reason to believe that a quick end to the Fed’s rate hikes looks likely based on the recent behavior of bank credit. Plotted in Chart 1 are month-to-month annualized percent changes in both bank credit, which includes loans, leases and securities on the books of commercial banks, and the monetary aggregate, M2. Yes, M2 growth slowed in the waning months of 2021 and M2 has been more or less contracting starting in April 2022. But notice that bank credit growth has slowed since December 2021 and bank credit has contracted in both September and October 2022. So, although the magnitudes of recent month-to-month percent changes in M2 and bank credit have differed, the trends are similar – smaller positives transitioning to negatives. So, from where does the notion of “booming” bank credit come?

Bank credit has two main components – loans and leases on banks’ books and securities on banks’ books. Plotted in Chart 2 are the month-to-month annualized percent changes in total bank credit, banks’ loans and leases and banks’ securities holdings. In the past 12 months ended October 2022, the annualized month-to-month growth in banks’ loans and leases has averaged 12.0 percent. But in this same time period, the annualized month-to-month growth in banks’ securities holdings has averaged 0.8 percent and contracted at annualized rates of 4.8 percent, 18.3 percent and 22.9 percent in the months of August, September and October 2022, respectively. As a result of the weak growth/contraction in banks’ securities holdings, total bank credit contracted in September and October 2022, despite robust growth in banks’ loans and leases.

“Veteran” economists remember, or should remember, that banks’ commercial and industrial (C&I) loans (business loans) are a lagging indicator of the business cycle according to the Conference Board, the organization that has been calculating and publishing indices of leading, coincident and lagging economic indicators for decades. This means that C&I loans tend to be increasing either just before the economy enters a recession or when the economy is in a recession. One reason that C&I loans behave as a lagging business cycle indicator might be that as the economy is near a recession or is in a recession, growth in sales revenues of businesses slows, business inventories begin to increase faster than sales and businesses, therefore, turn to bank loans to finance their inventories. Perhaps the Conference Board is doing a little double-counting regarding its index of lagging indicators inasmuch as a rising inventory-to-sales ratio for manufacturers also is a component this index. Plotted in Chart 3 are the quarterly averages of banks’ loans and leases as a percent of the quarterly averages of total bank credit from 1958 through 2019. The shaded areas are periods of economic recessions. Notice how banks’ loans and leases relative to total bank credit tend to peak just before a recession or during a recession. So, a peak in the ratio of bank loans and leases to total bank credit is associated with a recession or an imminent recession. Of course, we never can identify a peak until after the fact.

Now, let’s take a look at monthly data of banks’ loans and leases as a percent of total bank credit for the period from November 2021 through October 2022 (see Chart 4). The ratio has been rising steadily since March 2022. I doubt that it has reached its cyclical peak yet. But I would not now view the fact that banks’ loans and leases are increasing absolutely and relative to total bank credit as an optimistic signal for real economic growth. Moreover, in recent weeks, the spread between the yield on the Treasury 10-year security and the federal funds rate has become negative, or has inverted. My former and now deceased Chicago Fed colleague, Bob Laurent, did seminal research on the implications of this spread for real economic behavior back in the mid 1980s. He deduced that the behavior of this spread is a leading indicator of real economic growth. When this spread inverts, it is a strong signal that a recession is imminent. By the way, subsequent to Laurent’s research on this spread, the Confrence Board added it as a component to its index of leading indicators. Of course, “veteran” economists would know this.

In sum, the robust growth in banks’ loans and leases in the context of a contraction in total bank credit in recent months and the inversion in the 10-year Treasury security – federal funds yield spread tell me that a recession is imminent. My guess is that the recession will start in Q1:2023. As a “veteran” Fed watcher, I have observed that the cycle peak in the federal funds rate tends to occur just before or just as the economy enters a recession (see Chart 5). The Fed will hike the federal funds rate by 50 basis points at its upcoming December 13-14 FOMC meeting. That would take the federal funds rate up to 4.33 percent. I think the Fed will either hold steady at a federal funds rate of 4.33 percent at its January-February 2023 FOMC meeting or hike the rate by only 25 basis points. At the close on November 29, 2022, the federal funds futures market puts this cycle’s peak federal funds rate at 4.92 percent. My bet is that 4.92 percent will not be reached in 2023. So, in contrast with Randall Forsyth, I believe there are several reasons a quick end to the Fed’s rate hikes look likely.

Full disclosure. Mr. Forsyth emailed me on the morning of November 22, 2022, asking me to comment on the apparent disconnect between the Fed’s QT program and the vigorous expansion in bank credit. I responded in the evening of November 23, 2022, pointing out that total bank credit was contracting, only the loans/leases component was expanding vigorously. I touched on other things discussed in this commentary, including that I was of the opinion that the Fed was near the end of it cyclical hikes in the federal funds rate. Either my response to Mr. Forsyth was too late for him to make his deadline or it did not fit the theme of his column that he already had in mind. I may have decayed with age, but I have not mellowed.