Part II: Should Financial Markets Celebrate Powell’s Pivot?

Part II from a piece by our macro-economist Bob Gay:Should Financial Markets Celebrate Powell’s Pivot?

Two other developments might have given hawkish FOMC participants reasons to pause and reflect. For one thing, market measures of inflation expectations had declined significantly since the December meeting. This explanation, however, is not very persuasive because the Fed tends to rely on survey data on inflation expectations, which tends to be more stable than market measures that probably have been influenced by short-term developments such as the drop in oil prices.

Another, more persuasive piece of evidence, in my opinion, was the tightening of commercial bank lending standards at year-end. The survey data collected by the New York Federal Reserve each quarter likely were available to the FOMC prior to the January meeting. On the surface the data looks relatively benign with two exceptions. For one, more banks have been tightening standards on consumer lending for most of 2018.

Second and most important is that banks, which had been aggressively marketing C&I loans to their major corporate clients for the past two years thanks to the near-zero cost of funding from the Fed, suddenly swung to tighter standards. A glance at the history of these data reveals that such abrupt changes in lending standards often is a precursor to a weakening economy. Indeed, in an exhaustive study of lead indicators of financial crises, New York Fed researchers could find only one – namely, lending standards for commercial and industrial loans– that offered meaningful advance notice of recessions. The average lead time is about six months. Clearly, the data are not yet at ‘threshold’ levels of concern but are worth scrutiny this year.

Contrary to conventional wisdom that lays the blame for recessions on the level of interest rates, it is the availability of credit - or more precisely the lack thereof – that sends the economy into a tailspin. The emerging world already is feeling a shortage of US dollars as the Fed normalises its balance sheet. Tighter standards by commercial Banks also is likely to reveal the weak underbelly of the US debt, which this time includes leveraged loans and especially non-bank, non-bond direct lending in the so-called ‘private market’ for loans that total an estimated $700 billion. Some form of risky or toxic behaviour presages every recession, and most often credit markets are both the vehicle and the catalyst for those downturns.

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