Fed Survey Confirms Broader Economic Improvement

Information provided by the Federal Reserve Board in its October 2017 release of the Senior Loan Officer Opinion Survey (SLOOS) indicates that lending standards on commercial and industrial (C&I) loans to large and medium-sized firms continue to ease on net. The continued easing in standards on C&I loans suggests that that the loan stock of C&I loans continued to expand. It also confirms the lower unemployment rate as well as the recent growth in the nation’s economy.

According to the SLOOS, lending standards on C&I loans, the largest loan category on bank balance sheets, eased by 8.5 percent on net over the previous 3 months ending in late September/early October. The net easing on C&I loans reflected the 8.5 percent of respondents mentioning that standards on these loans had eased at their bank over the past quarter. Meanwhile, no senior loan officer reported tightening standards on C&I loans over the quarter.

The importance of these responses is illustrated in the figure above, easier lending standards on net coincide with growth in the stock of C&I loans held at FDIC-insured banks. At the same time, net lending standards on C&I loans can foretell a recession approximately one year into the future. The acceleration in net lending standards on C&I loans then indicates that a recession is unlikely in the next 12 months (a previous blog cited yield curve analysis by the Federal Reserve Bank of New York which put the recession probability over the next 12 to 18 months at approximately 10 percent), but also that the stock of these business loans should continue to grow.

Assessing prospects for the trend of C&I loans in the near future is important because the trend in the stock of C&I loans is inversely correlated with the direction of the unemployment rate. As illustrated by the figure above, periods of growth in the stock of C&I loans held at FDIC-insured institutions corresponds to a decline in the unemployment rate. Similarly, sustained decreases in the stock of C&I loans held by these banks coincide with an increase in the unemployment rate. Intuitively, growth in business investment, partly stemming from easier lending standards on business loans, spurs additional hiring thereby lowering the unemployment rate.

Previous analysis has noted that not only is the unemployment rate low, but it is also below the Congressional Budget Office’s (CBO) estimate of the natural (non-accelerating inflation) rate of unemployment. At the same time, the nation’s total economic output now exceeds CBO’s estimate of its potential level. The relationship between the locations of the actual unemployment rate relative to its natural rate and actual GDP relative to its potential level is captured by Okun’s Law:

(YPotential – YActual)/YPotential = c(uActual – uNatural Rate)

Okun’s law, which ignores the role of capital and the role of productivity in the determination of total GDP, posits that the percentage distance of actual GDP from its potential, (YPotential – YActual)/YPotential, is directly related to the gap between the actual unemployment rate and its natural rate, (uActual – uNatural Rate), with c denoting the factor relating changes in unemployment to changes in total output, GDP. The scatterplot above, which uses data going back to 1949, illustrates the direct relation between the two sides of the equal sign. Periods in which actual GDP exceeds its potential coincide with periods when actual unemployment rate is below its natural rate (bottom left box). Similarly, periods when the actual GDP is above its potential coincide with periods when the unemployment rate is below its potential (upper right box).

The results of the October iteration of the Fed SLOOS indicate that lending standards on C&I loans continue to ease. This result suggests continued improvement in the nation’s labor market and continued growth in the nation’s economy. However, monetary policy typically tightens in response to periods when actual GDP exceeds its potential, and there is little expectation that policy should deviate dramatically if the nominated Chairman is confirmed.

Although net lending standards on C&I loans, which continues to ease, is the theoretical input to estimating future macroeconomic conditions, demand for C&I loans weakened on net for the third consecutive quarter. The relatively weaker demand for C&I loans may be restraining the growth in the stock of these loans. In addition, despite the low unemployment rate, inflation is expected to return to a sub-2 percent rate.  At the same time, there is a possibility that some consensus emerges that doubts the accuracy of the current estimate of potential GDP.  If inflation remains low and potential GDP is higher than currently estimated, then current macroeconomic conditions would be still recovering and the policy rate should reflect this state of play.

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