Rate Hikes and Credit Tightening

How do the Fed's interest rate hikes affect bank lending standards? One way to find out is to directly ask banks whether they've tightened lending standards to borrowers. The Fed's Board of Governors does exactly that through its quarterly Senior Loan Officer Opinion Survey (SLOOS), which canvasses up to 80 large domestically chartered commercial banks about bank credit availability and loan demand. Prior research has shown that credit conditions as reflected in SLOOS responses can predict GDP growth and loan growth, while shocks to SLOOS credit conditions can impact bank lending capacity. In this week's post, we look at the extent to which recent movements in lending standards as measured in the SLOOS have correlated with the Fed's monetary policy tightening.

To measure the extent of Fed tightening, we use the two-year Treasury note yield, which reflects not only the current level of the fed funds rate, but also the market's expectations for near-term rate hikes. Figure 1 below shows the level of the two-year Treasury yield and, from the SLOOS, the net percentage of banks tightening commercial and industrial loans to large firms (a proxy for overall bank credit tightening), from the second quarter of 1990. The figure indicates that peaks in the two-year Treasury yield often occur several quarters prior to peaks in the SLOOS credit tightening measure. However, in the most recent episode of Fed monetary tightening, credit tightening has responded much faster, with the SLOOS measure rising in tandem with the two-year yield.

A cross-correlation analysis confirms that, over the full sample, current credit conditions are more closely related to past monetary tightening actions. Figure 2 below shows the correlation between the current SLOOS tightening measure and lags of the two-year yield. The figure indicates the highest correlation is between the current SLOOS credit tightening score and the two-year Treasury yield observed six quarters ago. Interestingly, the six-quarter time frame aligns with popular estimates of the lag with which monetary policy affects the economy, which several studies have suggested is somewhere between 12 and 18 months.

But as Figure 1 hints, there may be less of a lag in the current episode of monetary tightening. Figure 3 below provides additional evidence suggesting this may be the case, plotting the rolling three-year correlation between quarter-over-quarter changes in the two-year Treasury yield and the SLOOS credit tightening measure. The rolling correlation rose to 0.44 in the second quarter of 2023, the highest since the first quarter of 2006.

This could mean that the transmission of monetary policy to credit conditions is faster this time, compared to the typical lag of 12 to 18 months. Notably, the pace of Fed rate hikes has been faster and steeper in this cycle compared to the typical Fed rate hiking cycle, which may be one reason transmission may be faster. However, while shorter lags would help the Fed achieve its inflation target in a timelier manner, it could also mean that the factors underlying today's elevated inflation (as core PCE inflation was 4.1 percent year over year in June) are proving to be stubborn in the face of 500 basis points of fed funds rate hikes.

Views expressed in this article are those of the author and not necessarily those of the Federal Reserve Bank of Richmond or the Federal Reserve System.