Banks Are Doing the Fed’s Work

After a late start the Federal Reserve has been raising interest rates in an attempt to stem inflation. The way that works is that higher rates depress the business cycle, increase the rate of unemployment and, typically, result in a recession. Although inflation has come down a bit, the Fed’s job is nowhere near done. However, they may now be getting help from the banks. The banks are doing the Fed’s work because they are tightening terms of credit for commercial real estate and for medium and large businesses.

Less Credit Means Less Business Spending

A Federal Reserve survey of bank lending officers indicates that banks are tightening terms for loans as well as raising rates on those loans. Consumer loans and credit cards will be subject to tougher rules and restrictions. This is historically normal for when the Fed is raising rates and, according to Bloomberg, mutually self-reinforcing. Because businesses borrow in order to finance future endeavors, there is a lag between when banks tighten credit and when effects ripple through the economy. Both household borrowers and businesses are affected and cut back on spending as a result.

Recession Projected for 2023

As we have stated at Top Gun Options, the country is probably already in a recession in terms of businesses and profits. However, the strict definition of a recession is retrospective. It looks back at the preceding three months. And as we have noted at Top Gun Option the formal definition of a recession has also been changed (as well as the definition of inflation) from years ago. Anyway, because of the time lag built into higher interest rates and banks tightening credit, we can expect a formal statement of there being a recession sometime in 2023 instead of in 2022. Projections by various economists put the odds of a 2023 recession by the current formal definition at 75% with it starting in the third quarter and unemployment going from 3.75% in the fall of 2022 to somewhere around 5.6% by the third quarter of 2023.Where Will Interest Rates Land?

The Fed keeps saying that they will continue to raise rates until inflation is down to 2% and wishful thinking on part of the market keeps causing brief rallies. Although the current interest rate target of the Fed is 4% it is more likely that they will get to 5% before recession sets in and inflation subsides. The banks joining the effort by tightening credit terms will help keep the Fed from going higher and add to the risk of the Fed’s effort overshooting and making the recession much worse than desired. Bank loan rates are always higher than the Fed’s rate but the contribution of the banks is in the terms of loans, credit scores need to be higher, loan amounts are lower, and meanwhile banks are expecting to have to write off more and more bad loans anyway.

Tightening Credit and the Market

As businesses experience the results of tighter credit, the results will show in their quarterly financial reports. To the extent that investors and traders anticipate or react to poorer quarterly reports stocks will fall. Because the market continually seeks to anticipate the future, a dynamic seems to be built into the market that when recession looms and prices ought to go down, they go up instead because traders believe that the Fed will finally back off of its interest rate increases. That does not mean banks will change their tune. What one can reasonably expect is that the market will fluctuate as earnings come in next year, as the Fed continues or modifies their rate increases. This will be trading in the trenches until a clear path becomes clear, either a long, severe recession or a recovery. This will be the time that one should be trading in a trusted trading squadron like at Top Gun Options where we potentially print money no matter where the market is headed.