Financial markets of all kinds have been unusually volatile in the past few months. In just the last couple of weeks, investors were buffeted by three different price movements: Oil prices soared, gold prices surged, and the dollar continued its protracted slide. Investors showed their uneasiness about the future by pushing stock prices steeply lower.
In the summer, price volatility was most evident in the stock prices of home builders and mortgage lenders, and in the markets for asset-backed commercial paper and collateralized debt obligations. More recently, as a broader range of financial companies reported sizeable losses on assets in their portfolios, investors began to reassess their forecasts and anticipate slower economic growth in the next several quarters. If commercial and investment banks are forced to trim their risk exposure and shore up their capital positions, might they not scale back their extension of credit, their provision of backup lines, and their willingness to make markets in risky securities? Could such a retreat precipitate a credit crunch severe enough to slow the economic expansion?
Credit crunches are periods in which borrowers have trouble obtaining credit from banks and capital markets at a given interest rate. Some borrowers might be able to obtain credit on more restrictive terms than those that prevailed before the crunch; others might be unable to obtain credit at any price. Crunches typically come about when lenders suddenly revise their opinions about risk or do not have enough capital to add more assets to their balance sheets. Restrictive monetary policy can also induce a credit crunch by limiting reserves to the banking system.
Credit crunches can pose serious risks to economic expansions because the rationing of credit will probably make some investment projects infeasible, and could even squeeze highly leveraged borrowers to the point of business failure. The resulting decline in production and employment, if it were to spread throughout the economy, could contribute to a recession. This possibility has taught monetary policymakers to be wary of imposing restrictive monetary policies and credit controls during periods of credit market fragility.
Indeed, since August, when signs of financial market distress emerged, the Federal Open Market Committee has dropped its federal funds rate target by 75 basis points and reduced the spread between the funds rate and the primary credit borrowing rate by 50 basis points. These actions were designed, at a minimum, to avoid an inadvertently restrictive policy at a time when lenders were becoming more cautious.
The Federal Reserve’s Senior Loan Officer Opinion Survey provides one gauge of credit market tightness and puts it into some perspective over time. From the latest survey, we learned that nearly 20 percent of the respondents reported tightening standards for commercial and industrial loans to medium- and large-sized companies during the third quarter. Nearly 40 percent of them reported increasing the spread of loan rates over their bank’s cost of funds. Senior lenders reported that their restraint was focused primarily on commercial real estate and consumer installment lending. Importantly, however, the tightening is a recent development; similar surveys conducted earlier this year found scant evidence of it. It is too soon to tell how long it will persist or how severe it might be.
There is little evidence, from the latest survey at least, of a widespread curtailment of credit. How telling that source of information will prove to be is unclear because various other financial institutions now play key roles in the credit-extension process. If they are retrenching at a faster pace than commercial banking organizations, we might see more credit market restraint than the survey suggests. At the same time, if the survey began to show a commercial bank retreat and nonbank financial firms stepped up their credit market activities, we might experience only a modest credit adjustment.
Daniel Webster once remarked that “ Credit is the vital air of the system of modern commerce.”* Soon enough, we will know what is in the air.
*From Senator Daniel Webster’s remarks in the Senate in favor of continuing the charter of the Bank of the United States, March 18, 1834, as quoted in The Writings and Speeches of Daniel Webster, vol. 7, p. 89 (1903).