Financial conditions are tightening again to cool the overheated US economy

Orlando, Florida, Oct. 25 (Reuters) – After 18 months of relentlessly rising borrowing costs, the U.S. economy is regaining momentum, begging the question of when tight financial conditions will slow.

After 525 basis points of interest rate hikes, financial conditions are now the tightest and biting in over a year. This is exactly what the central bank wants, and it doesn’t want the teeth of expensive money to sink deep into the real economy for fear of hampering its other mandate of maximum employment.

The main reason for those stressed conditions is renewed asset price losses. Treasury yields are up 5% or more from 2006-07 and Wall Street stocks are down about 10% in three months, with high-yield debt spreads finally widening.

JP Morgan strategists estimate that the impact of tightening financial conditions on GDP will take one to two years to be felt. 2022-23 may be well into next year before the full effects of tightening manifest in the real economy.

But the warning signs are already flashing.

One of them is renewed weakness in US regional bank stocks. All but a few dozen of the 4,000-plus banks in the United States are 'small’ or 'medium-sized’, and are important to local business and employment.

There are about 33 million small businesses in the United States, and they account for about 40% of all jobs nationwide. Their relationships with small and regional banks could not be stronger.

Goldman Sachs research earlier this year showed that nearly 70% of small firms’ commercial and industrial loans came from banks with less than $250 billion in assets, and 30% from banks with less than $10 billion in assets.

The KBW regional banking index hit a five-month low on Tuesday, down 20% since late July, and returning to the lows it hit after the March regional banking shock.

The financial pain for these banks means that credit to their individual and corporate customers will be scarce and expensive.

Figures from the National Federation of Independent Business showed that small businesses paid nearly 10% on their short-term loans in September, the highest interest rate since September 2006.

The increase in October was the largest since February 2001, and history shows that when small firms’ borrowing costs reach these levels, a recession usually follows.

„Fed policy is acting as textbook predicted, and firms are facing higher capital costs,” Torsten Slok of Apollo Global Management wrote on Monday. „The result is lower (capital expenditure) costs and less hiring.”

Best hope

The tightening of financial conditions in recent months has seen the central bank raise the policy rate by only 25 basis points over a period, which is unusual.

Since mid-July, they have tightened by about 125 basis points, according to Goldman Sachs, with about 50 basis points due in equal measure to lower stock prices and higher long-dated bond yields.

Analysts at Morgan Stanley said conditions have tightened by about 75 bps since the central bank’s pause in September, much of it from the explosion in bond yields.

BNP Paribas analysts calculate the impact on GDP growth of tighter financial conditions to be equivalent to a recent 40 basis point rate hike. Almost a third of the index of bank financial conditions since April was made up of higher bond yields.

That’s important because the yield on consumer and business lending rates, as well as mortgage rates, is dropping by 8% for the first time in more than 20 years.

Existing home sales are rising at their slowest rate since 2010, mortgage applications have fallen to levels last seen in the mid-1990s, affordability has fallen, and prices have started to head south in many areas.

BNP Paribas economists say the full effects of the central bank’s tightening are yet to emerge. „Our base case is still a recession in 2024. A mild one compared to history, but a decline nonetheless,” they wrote last week.

To be sure, the economy still seems to be humming along nicely. Broad measures of the labor market and consumer spending continued to beat forecasts, and GDP growth was much stronger than most observers expected.

Financial conditions were much tighter a year ago, but real annual growth was 2% in the second quarter and 5% in the third quarter. As with the inverted yield curve, is this pattern really that different?

We will soon find out.

Several Fed officials, including Chairman Jerome Powell, have been on the stump this month, and tighter financial conditions cooling the economy rather than rate hikes have been specifically mentioned or alluded to.

They now basically sit back and hope for the best.

(The views expressed here are those of the author, a Reuters columnist.)

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