August Economic Commentary: Uncertain Economic Outlook May Cause Banks to Tighten Lending Standards Further in H2 2023

The lagging effects of the most aggressive monetary tightening cycle over the past 40 years are manifesting themselves in the banking system and working their way through the overall economy. Forward-looking indicators suggest that the huge rise in interest rates and tightening of bank lending standards will continue to cause the economy to slow as we move through 2023. Meanwhile, inflationary pressures continue to ease, raising hopes that the Fed is done, or nearly done, with their interest rate raising campaign.

CPI, GDP & Consumer Spending 
The June CPI report showed inflation increasing by 0.2 percent during the month, dropping the headline year-over-year number to 3.0 percent – a 27-month low. It was just last June that the headline CPI peaked at 9.1 percent year-over-year. The largest component of the CPI is shelter: 34 percent of CPI and 43 percent of core-CPI. Real time data show rental rates declining year-over-year through July. As the decline in shelter feeds into the CPI calculation, further improvement in inflation figures is expected. Assuming monthly increases of 0.2 percent for the remainder of the year, the headline CPI would end the year around 2.8 percent.

The initial reading of Real GDP growth for second quarter 2023 came in better than expected at a 2.4 percent annual rate accelerating from 2.0 percent in first quarter. Business investment growth provided the majority of the second quarter strength with 7.7 percent annualized growth.

Consumer spending in second quarter 2023 slowed to a 1.6 percent annual rate from 4.2 percent in first quarter in the face of higher prices. After a strong start to the year in January, real (inflation-adjusted) retail sales have stalled and are down 1.6 percent year-over-year through June. Year-over-year real retail sales have been flat or negative in seven out of the last eight months.

The ISM manufacturing index for July came in at 46.4 for the ninth consecutive month below 50, indicating contraction in the manufacturing sector. Only two of 18 industries reported expansion in July compared to 11 of 18 a year ago. The new orders index has been in contractionary mode for 11 consecutive months.

Treasury Receipts & Lending Markets 
Another indication of the slowing economy has been the decline in federal government tax receipts. Treasury receipts are down $423 billion in this fiscal year compared to the same period in 2022, while outlays are up $455 billion – including $131 billion due to higher interest payments. The decline in tax receipts is mainly due to lower receipts from individual income taxes.

The latest Senior Loan Officer Survey by the Fed shows that, even though the banking crisis has faded, credit conditions remain unusually tight and demand for loans remains weak.

The net percentage of banks tightening standards on commercial and industrial (C&I) loans and credit card loans hit new cyclical highs. The tightening of C&I loans is a reaction to business bankruptcies having hit their highest levels since October 2020.

Regarding their outlook for the second half of 2023, banks reported expecting to further tighten standards on all loan categories. Banks most frequently cited a less favorable or more uncertain economic outlook and expected deterioration in collateral values and the credit quality of loans as reasons for expecting to tighten lending standards further.

The combined impacts of tighter lending standards at banks, an inverted yield curve, and the outflow of deposits from banks has caused the credit cycle to turn so that the supply of credit and the demand for credit are both contracting – not a good mix for a credit-driven economy. 
Through June 2023, the Leading Economic Index (LEI) has been down for 15 consecutive months and is now at the lowest level since July of 2020. Historically, such a string of declining readings has only happened when the economy is in or nearing a recession.

Employment Trends & The Labor Market 
The July employment report showed an increase of 187,000 in non-farm payrolls, and the prior month was revised down to 185,000. These are the two weakest monthly gains in two and a half years. Temporary help employment continued to decline, falling 22,000 – an indication of a softening labor market – and the average weekly hours worked fell only slightly from 34.4 to 34.3. The household survey was a bit stronger, enabling the unemployment rate to decline to 3.5 percent from 3.6 percent.

Average hourly wages are growing at 4.4 percent year-over-year, similar to the year-over-year growth since March. An important metric to monitor is labor market productivity. The second quarter 2023 number was released showing a 3.7 percent increase in productivity on an annualized basis. If that continues, then wage growth at the 4.0 percent year-over-year level is not a problem. Associated with the improvement in productivity in second quarter, unit labor costs increased only 1.6 percent on an annual rate which, if continued, will help the overall inflation picture.

U.S. Credit Rating & The Fed 
On August 1, the credit rating firm, Fitch Ratings, cut the rating on U.S. debt by one notch from AAA to AA+. The downgrade of U.S. creditworthiness by Fitch likely means a more critical review of any new fiscal stimulus for the foreseeable future. The federal government is running near a 6.3 percent deficit to GDP ratio at a time of a fully employed economy. This has never happened before. Deficits in a fully employed economy are typically 1.0 to 2.0 percent. The current deficit will likely only move higher if unemployment increases.

As expected, the Fed increased the Federal Funds by an additional 25 basis points at their July 26 meeting, taking the target range to between 5.25 and 5.50 percent.

Markets are now pricing in a lengthy pause in interest rate actions before the first interest rate cut occurs in the spring of 2024.