April 6, 2017
Although the Recent Weakness in Bank
Credit Growth May Not Be a Concern to Others, It Is to Me
Starting around this past December, growth in commercial
bank credit (loans and securities) slowed precipitously (see Chart 1).
Annualized 13-week growth in bank credit of late is the slowest since the
summer of 2013. This weakening in bank credit growth has been noticed and
commented on by at least two economic analysts besides me – University of
Oregon economics professor Tim
Duy and Goldman Sachs economist Spencer Hill. These two analysts have
concentrated on the weakness in one
component of bank credit – commercial
and industrial(C&I) loans – and concluded that there is nothing to get
excited about with respect to the pace in U.S economic activity. I do not share
their sanguine view. Notice that the data in Chart 2 show that the growth in
bank credit excluding C&I loans
also has slowed precipitously since this past December. If history is any guide, this weakening in bank credit growth excluding C&I loans is cause for
concern with regard to the pace of economic activity.
Chart 1
Chart 2
Professor Duy, employing sophisticated econometrics
techniques, elegantly corroborated what the Conference Board told us decades
ago – the behavior of commercial and industrial bank loans is a lagging indicator of economic activity.
What Professor Duy did not do was explain
in Dick and Jane (Mr. Pero, that was for you) or otherwise why this is the
case. As the data in Chart 3 show, percentage changes in business inventories
have a relatively high contemporaneous correlation (0.57) with percentage
changes in bank C&I loans. So, businesses rely heavily on bank loans to
finance their inventories. To understand why bank C&I loans are a lagging indicator of economic activity,
we need to understand the behavior of business inventories relative to business sales in the business cycle. As business sales
start to slow, inventory growth tends to picks up. This is shown in Chart 4. This
increase in inventory growth relative to sales growth typically is involuntary. With slower growth in revenues,
businesses rely even more heavily on their banks to finance their higher involuntary
inventory builds.
So, a surge in inventories and C&I loans often is
associated with a slowdown in the growth of final demand for goods and
services. Hence, bank C&I loan growth often tens to lag growth in final demand for goods and services. That is, the
behavior of bank C&I loan growth provides more information as to where the overall
economy has been rather than where it
is headed.
Chart 3
Chart 4
Goldman’s Mr. Hill hypothesized that the recent weakness
in bank C&I loan growth was due to the re-opening of the bond markets to
oil and gas industry borrowers. According to Mr. Hill, when energy prices fell
in 2015 and 2016 (obviously due to the anticipation of a Trump administration
that would promote oil/gas exploration and the elimination of environmental
regulations), oil and gas producers had to tap their bank lines of credit
because bond-market lenders became more wary. According to Mr. Hill, then, the
recent weakness in bank C&I loan growth is largely attributable to a more
receptive bond market toward oil and gas industry borrowers and does not signal
an imminent slowdown in U.S real GDP growth from its blistering Q4:2016
annualized pace of 2.1%.
And I agree with Messrs. Duy and Hill that the recent
slowdown in bank C&I growth is not
alarming with regard to the future course of U.S. economic activity. But I
believe bank C&I loan growth is a red herring with regard to the future
course of the economy. Instead, I focus on the growth in bank credit excluding the C&I loan component.
And as I mentioned at the outset of this commentary, growth in bank credit ex
C&I loans also has weakened precipitously starting in December 2016.
I am arguing that thin-air credit growth (you knew it was
coming) excluding C&I loans is a better leading indicator of the pace of
domestic demand than is thin-air credit growth including C&I loans. I will demonstrate this to you by
comparing changes in correlation coefficients when thin-air credit leads and lags growth in domestic demand. Plotted in Chart 5 are
year-over-year percent changes in quarterly observations of the sum of depository
institution credit (including C&I loans) and the monetary base (the sum of
depository institution reserves at the Fed and currency) along with
year-over-year percentage changes in quarterly observations of Gross Domestic
Purchases. The contemporaneous correlation
coefficient between these two series is relatively high 0.61. (Remember, a
perfect correlation is 1.00). Plotted in Chart 6 is the same thing except that C&I
loans are excluded from the thin-air
credit growth aggregate. The contemporaneous
correlation coefficient between growth in thin-air credit growth excluding C&I loans and growth in
Gross Domestic Purchases is 0.55 – not bad for private-sector analysis, but
less than the 0.61 correlation coefficient when C&I loans are included in thin-air credit growth.
Chart 5
Chart 6
Remember, though, I am trying to discern which measure of
thin-air credit growth is a better leading
indicator of economic activity – thin-air credit growth with C&I loans or
excluding C&I loans. So, we need to see what happens to correlation
coefficients when thin-air credit growth leads and lags Gross Domestic
Purchases growth. Contemporaneous correlation
coefficients tell us nothing about leading or lagging characteristics. Does
thin-air credit growth “cause” Gross Domestic Purchase growth or vice versa? When thin-air credit growth including C&I loans is advanced by
one quarter, implying that today’s thin-air credit growth “causes” tomorrow’s
Gross Domestic Purchases growth, the correlation coefficient falls from 0.61 to 0.59. When thin-air
credit growth excluding C&I loans
is advanced by one quarter, the correlation coefficient rises from 0.55 to 0.57. Now let’s retard thin-air credit growth by
one quarter, implying that Gross Domestic Purchase growth “causes” thin-air
credit growth. When we do this, we find the correlation coefficient for
thin-air credit growth including
C&I loans is 0.61, the same as its contemporaneous correlation coefficient
and higher than 0.59, its correlation
coefficient when thin-air credit growth including
C&I loans is advanced by one quarter. These changes in the correlation coefficient suggest that thin-air
credit growth including C&I loans
is a lagging indicator of economic
activity. When thin-air credit growth excluding
C&I loans is retarded by one quarter, the correlation coefficient falls to 0.51 compared to its
contemporaneous level of 0.55 and its one-quarter-advanced level of 0.57. These changes in correlation coefficients
suggest that thin-air credit growth excluding
C&I loans is a leading indicator
of economic activity.
By the way, in case you think that there might not be
much left of depository institution credit once C&I loans are excluded,
take a look at Chart 7. From 1952 through 2016, the median percentage of
nonfinancial business loans from depository institutions as a percent of total
depository institution credit was 14.7. In 2016, C&I loans accounted for
13.9% of total depository institution credit. So, C&I loans, although a
significant portion of total depository institution credit, are far from the
whole ball of wax.
Chart 7
Okay, now that I have established (beyond a shadow of
doubt?) that thin-air credit excluding
C&I loans is the better leading indicator of the two, let’s see how it has
been behaving on a year-over-year basis in recent weeks and months. This is
shown in Chart 8. Although year-over-year growth in weekly observations of
commercial bank credit excluding
C&I loans has been slowing since October 2016, there has been some
acceleration in the growth of combined
bank credit ex C&I loans and the monetary base in recent weeks. Mind you,
at 3.4% in the 52 weeks ended March 22, growth in this version of thin-air
credit still is weak in an historical context.
If commercial bank credit is not boosting modestly the growth rate of thin-air credit of late, it must be the
monetary base. As can be seen in Chart 9, one important factor that has been
increasing the monetary base since January is the decline in Treasury deposits
at the Fed. All else the same, when these deposits decline, depository
institution reserves increase. But as the April 15 tax payment date approaches,
Treasury revenues will spike up. To the degree that these revenues are
transferred to the Fed, all else the same, the monetary base will decline. In
addition, when the Fed raises the federal funds rate, it has to reduce the
supply of reserves in order to push up the interest rate. In sum, I would
expect that in coming weeks the monetary base will be contracting. Unless there
is a resurgence in bank credit growth, total thin-air credit growth will slow
from an already tepid pace.
Chart 8
Chart 9
On January 17, I published a commentary entitled “2017 – Shades of 1937”.
In the commentary, I wrote: “Based on the recent slowdown in thin-air credit
growth, I believe that a significant slowdown in the growth of nominal and real
U.S. domestic demand will commence in the first quarter of 2017.” Perhaps
“significant” was too strong an adjective, but I hold by my prediction of a
slowdown in the growth of real domestic demand. Despite relatively strong
employment gains in January and February and hinted at by the March ADP
employment guesstimate, real GDP growth in Q1:2017 appears to have come in at
an even weaker pace than that of the paltry 2.1% annualized in Q4:2016. (Perhaps
the depths of the productivity labor pool are being plumbed, requiring a larger
quantity of workers to get a given amount of output produced.) The Federal
Reserve Bank of Atlanta’s GDPNow
Q1:2017 real GDP annualized growth estimate as of April 4 is 1.2%. Of course,
this does not yet incorporate March data. Real personal consumption, which has
accounted for about 68% of total real GDP in recent years, is coming in weak
based on January and February readings. If the March level of real personal
consumption were to be unchanged from the February level, Q1:2017 real personal
consumption will have grown at an annualized
pace of 0.3% -- not 3.0%, but 0.3%.
In order for Q1:2017 real personal consumption expenditures to grow at the 3.5%
annualized pace of Q4:2016, March real personal consumption would have to grow
at annualized rate of 9.75% vs. February. How likely is this given that from January
2010 through February 2017 there have been only two month when real consumption
expenditures grew by at least 9% annualized month-to-month? The median
month-to-month annualized growth in real personal consumption from January 2010
through February 2017 has been 2.3%. If March real personal consumption were to
grow at an annualized 2.3%, this would imply Q1:2017 real personal consumption
growth of only 1.1%. What is arguing
against a strong reading of Q1:2017 real personal consumption growth is the
annualized 17.1% Q1:2017 contraction in
unit sales of light motor vehicles, the largest quarterly contraction since the
30.2% contraction in Q4:2009, the quarter after the federal “cash-for-clunkers”
program that boosted motor vehicle sales.
In conclusion, with or without C&I loans, thin-air
credit growth remains weak. Weak thin-air credit growth implies weak growth in domestic
demand. If the Fed does raise its federal funds rate target a couple of more
times this year as it has indicated it might, this would weaken thin-air credit
growth further and would likely bring on a recession. My bet is after seeing
the weakness in Q1:2017 real GDP growth and the lack of rebound in early
Q2:2017, the Fed will hold its fire.
Paul L. Kasriel
Founder, Econtrarian,
LLC
Senior Economic and Investment Advisor
1-920-818-0236
“For most of human
history, it made good adaptive sense to be fearful and emphasize the negative;
any mistake could be fatal”, Joost Swarte
