March 24, 2023 | 13:27
(Credit) Crunch Time for the Economy?
(Credit) Crunch Time for the Economy?
“Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation. The extent of these effects is uncertain.” — FOMC Statement, March 22, 2023
The banking sector stress in the past two weeks has clearly ratcheted up the risks for the broader economic outlook. At a minimum, it will reinforce the ultra-aggressive central bank tightening of the past year. Quantifying the impact in these early days is next to impossible given that: a) no one can say for certain whether the squall will soon blow over or intensify; and b) the transmission of financial system strains to the economy is imprecise. On balance, we suspect the turmoil will tighten lending conditions notably in the U.S. and Europe (and less so in Canada and Australia), cutting into already-softer capital spending trends, and denting what had been a resilient consumer. We have been in the mild recession camp for the past six months on the North American economy for 2023, and will freely allow that it was beginning to look like an overly dour forecast—until now. The combination of the near-record rate hikes of the past 12 months and a moderately tighter credit backdrop points to a contraction in the economy in the coming quarters, though the ultimate depth and duration will revolve around how long the current turmoil persists.
The banking stress will affect the U.S. economy via three channels—credit, confidence, and conditions (financial). Credit is about to get scarcer and more expensive. Loan growth was already slowing due to higher rates and tighter standards, but the trend could gather pace. Credit spreads have widened in the past two weeks, led by financial firms, though they are far removed from past blowouts (Chart 1). According to the American Bankers Association, credit conditions for consumer and business loans improved in Q1, but remain poor even before the latest financial stress. Smaller regional banks that are losing deposits will be forced to curb lending; while larger lenders may not plug the gap if they fear a recession. Smaller banks (outside the top 25 by assets) accounted for 41% of total bank loans in February and 70% for the commercial real estate sector. The office segment could take another body blow, with property values already down 25% from a recent peak (Chart 2). Rising bank funding costs could translate into higher loan rates for businesses and households. Small business confidence is already at recession levels and could sag further, depressing investment and hiring.
The impact on financial conditions is harder to pin down. Despite the slide in bank shares, equity markets have held up fairly well. The Chicago Fed’s measure of financial conditions tightened only modestly in the two weeks to March 17 (Chart 3). While conditions had weakened materially in the past year, they are looser than normal and not yet tight enough to cause a severe downturn.
The three Cs will challenge the three pillars of resilience. Long after the final stimulus cheques were sent out in 2021, consumer spending has been buttressed by excess savings, pent-up demand for deferred services, and stunningly strong job growth. That’s why we see just a shallow downturn. In fact, after the latest upswing in jobs and spending, we started to doubt whether the economy would shrink at all. Post-turmoil, however, even if extra savings and pent-up demand are likely to last for the remainder of the year, hiring will take a hit, undercutting consumer confidence and spending. In addition, demand for big-ticket items, such as homes and autos, could be held back by tighter credit. While home sales may have bottomed, the recovery could be delayed given that mortgage rates are still well above 6% and new applications have fallen back to cycle lows.
It’s too early to judge how much the banking stress will weigh on the economy—it depends on how long it lasts and whether it spreads. The Fed’s initial stab was to modestly lower its GDP growth outlook, though its view for this year (+0.4% over four quarters) is still somewhat firmer than ours (-0.2%). For now, we suspect the turmoil will largely offset prior upside risks, preserving our call for a shallow downturn around mid-year.
On the plus side, consumers could see some inflation relief. By depressing oil prices, the financial turmoil could lead to more savings at the pumps. It has already dampened inflation expectations, with one implied Treasury metric hitting a two-year low (Chart 4). If workers expect slower price increases, they could rein in wage demands. And, businesses might face a tougher time passing cost increases to customers.
While Canada’s relatively strong financial sector has largely stayed out of the recent fray, it doesn’t mean that the domestic economy will emerge completely unscathed. Almost no one would compare this episode with 2008, but we can still glean lessons from that traumatic series of events. At that time, Canada was widely recognized as having the healthiest banking system in the world, yet credit conditions still tightened markedly amid the waves of uncertainty, triggering an equally deep downturn in capital spending and the broader economy (Chart 5). The added hit from much weaker exports and commodity prices led to a 4% y/y drop in real GDP in the four quarters after Lehman Bros. went under, actually slightly exceeding the decline in U.S. GDP over the same period. (Where Canada really shone was on the recovery out of the deep downturn.)
According to the BoC’s Senior Loan Officer Survey, business lending conditions were slightly on the tighter side of normal in Q4. Most of that somewhat tighter landscape was on the price side, while nonprice conditions were in fact a bit looser than typical. Capital spending had already begun to lose pep late last year—one of the main reasons GDP growth stalled in Q4 was a surprisingly soft 5.5% drop in business investment after three quarters of solid recovery. From the perspective of borrowers, the BoC’s Business Outlook Survey reported a notable tightening in conditions (Chart 6). While not nearly as tight as in 2008, it’s among the biggest moves in the 23-year history of the survey—and that was before the events of the past two weeks. Not surprisingly, the same survey shows that business plans to boost capital spending have faded fast from very strong levels.
Lending to households, and consumer spending in general, tend to be less susceptible to shifts in credit conditions and more dictated by moves in interest rates and employment. Still, financial market turmoil and the spillover to credit conditions can undercut confidence and spending. While admittedly an extreme example, consumer spending turned on a dime in late 2008, and fell heavily for two quarters. The BoC’s loan officer survey only began tracking household lending conditions in 2017, so there’s not much history. Still, we know that conditions tightened sharply at the start of the pandemic, especially for nonmortgage consumer loans, but then quickly backed off (Chart 7). At the end of last year, mortgage lending conditions were seen as roughly normal, while they were a bit tight for nonmortgage loans, particularly on the nonprice side.
The main point is that even with a relatively strong and stable banking sector, credit conditions may still tighten somewhat amid the turmoil in other economies. In other words, Canada is not an island. And, businesses were already reporting that credit conditions were tightening in the lead-up to recent events, with some preliminary signs that households were also facing a somewhat stricter backdrop. Any further tightening will reinforce the 425 bps of policy rate increases over the past year, and—as for the U.S.—raise the odds of an outright downturn in the broader economy in the coming quarters. At the same time, this would bring forward the point at which the Bank of Canada could begin to take its foot off the brakes, especially with inflation beginning to relent.