Fed: U.S. banks tighten loan standards, see lower demand in Q4 of 2022

The Federal Reserve's January Senior Loan Officer Opinion Survey — which involved loan officers at big American banks — has revealed that major banks tightened loan standards and experienced lower loan demand in the last quarter of 2022.

According to the Fed, commercial and industrial companies needed higher credit scores than usual to apply for loans. The same standard applied to mortgage borrowers. This coincided with fewer loan requests from business entities and retail consumers throughout October to December 2022.

The Fed predicted that weak loan demand would resume in 2023, saying, "Banks, on balance, reported expecting lending standards to tighten, demand to weaken, and loan quality to deteriorate across all loan types."

A weaker loan demand last quarter was tied to the Fed's hawkish monetary policy and the need to navigate an uncertain economic environment. In 2023, the Fed expects further interest rate hikes, lower spending, improved supply chain and lower need for cash reserves will be the main drives for weak loan demand.

In March last year, the Fed began a monetary tightening cycle, incrementally increasing the benchmark interest rates to cool inflation. The rates rose from near zero to range between 4.5 percent and 4.75 percent following the Federal Open Market Committee (FOMC) meeting last week.

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The central bank claims that its aggressive monetary approach and its impacts — including softening the job market and lower consumer demand — are necessary for lowering inflation rates. It maintains an inflation target of two percent.

“It is important that overall financial conditions continue to reflect the policy restraint that we're putting in place in order to bring inflation down to 2%."

Jerome Powell, Chair of U.S. Federal Reserve

After last week's meeting, Fed chairman Jerome Powell addressed the public, acknowledging the significant tightening over the past year. Analysts believe that Powell's public statement signaled less hawkish monetary policy in the coming months.

However, there were some signs of easing financial conditions, which experts said could make the Fed decide to maintain its aggressive policy for a longer period. Goldman Sachs reported that the Financial Conditions Index was down two basis points to 99.57 last week. Economists said U.S. financial conditions should remain right for the Fed's plan to work out.

The San Francisco Fed also published a report on Monday, showing higher bond yields against lower stock prices, signaling the easing of financial conditions. It said further tightening was necessary to bring down inflation to the Fed's target.

'Fed is fighting problems of its own creation'

BetterMarkets co-founder and CEO Dennis M. Kelleher said the Fed had been taking actions that decoupled asset pricing from risk from 2008 to 2022 and "ignited a historic borrowing and debt binge." These problems become more prevalent in the wake of the macroeconomic uncertainty that the U.S., and many parts of the world, face today.

"Put differently, the Fed is in many ways fighting problems of its own creation," Kelleher added. "And considering the scale of the problems, it is very difficult to solve without some damage."

Kelleher explained that since the financial crisis in 2008, the central bank has become more focused on achieving short-term objectives. He said the Fed failed to prioritize long-term risk management and even abandoned several basic principles.

The executive added that the Fed put too much emphasis on inflation expectations. Before the pandemic, the Fed was concerned about expectations of low inflation, while now it is concerned about high inflation.

Kelleher warned that the Fed could repeat a similar mistake if it did not re-assess its previous policy approaches. He added that the current situation left the Fed no margin for error in the effort to prevent the economy from free falling.